Tax-free annuities can help supplement an IRA plan
Boston — It's hard enough to come up with a new product for retirement savings, without having the tax collector fight you all the way.
That's the problem several firms have faced in recent years as they tried to match the diversified investment benefits of a mutual fund with the tax-deferred status of an insurance company annuity. But in at least three rulings between 1977 and 1981, the Internal Revenue Service (IRS) told these companies their products were illegal - that they were vulnerable to abuse by people who were not looking for a long-term retirement investment, but wanted a short-term tax dodge.
Now, some of the companies think they may have gotten it right, and they have a brand new tax law to back them up.
The original products were a variation of the traditional insurance annuity product. Normally a customer purchases an annuity from an insurance company, makes deposits every month or several times a year, and lets the insurance company manage the assets. The interest builds up tax-free until retirement, when the policyholder is likely to be in a lower tax bracket.
For the IRS, one key to an annuity's tax-deferred status is the fact that the customer does not have control over the assets, that the insurance company owns and manages them. That is why the IRS looked with disapproval at the variation devised by the insurance and mutual fund industries.
In this version, misnamed a ''wraparound annuity,'' a customer actually purchased the annuity from the insurance company, even though it was marketed by a mutual fund. In addition, the customer could choose from all the mutual fund's investment vehicles: equity funds, bond funds, and money market funds. Not only did the customer have a choice, he could also move the money from one fund to another as economic circumstances and his own personal situation changed.
And even though the money was nominally held by the insurance company, the mutual fund was managing it and making the investment decisions.
One of the first products to offer investors this choice was called ''Spectrum,'' sold by the Massachusetts Financial Services Company and Nationwide Life Insurance. Nearly $160 million worth of annuity contracts were written by the firms. Other mutual funds, including the Fidelity Group and Dreyfus, soon followed.
But in ruling against these products in 1981, the IRS ''took a very narrow view of an investor's access to the annuity investment,'' says Edward Costello, project manager at Fidelity.
In its ruling, the IRS said the annuities must be managed by the insurance company or its affiliate, and that the investment vehicles in the annuity could not be offered to the general public. So a separate fund controlled by the insurance company had to be set up.
This ruling was in the tradition of two previous IRS decisions. One, in 1977, was against a company that let investors take their own stocks and bonds and put them in the annuity. The investors could thereby change the makeup of the investment any time they acted. The company that fought that ruling, First Investment Annuity Company, eventually went out of business. The other ruling, in 1980, came against some savings and loans associations that let people move certificates of deposit in and out of their annuities.
Now, after three IRS rulings, the mutual funds and insurance companies think they have products that will pass IRS muster.
At Fidelity, it is called Fidelity Income Plus. While Fidelity is marketing the product, all the investments are controlled and managed by a separate insurance company, Pacific Fidelity Life. Even though the name of the investment , Fidelity Cash Reserves II, is similar to the Fidelity Group's other general-purpose money market fund, it is managed by the insurance company. Mr. Costello professes no concern that a product bearing his company's name is not being managed in-house.
''I don't think that's a major concern,'' he says. ''Insurance companies manage more money in this country than any other single institution. They've been at the investment game a lot longer than we have. We feel that people who invest (in this product) should be as comfortable with them as we are.''
At Massachusetts Financial, Spectrum has been changed to Compass. In this case, the mutual fund gets to do the managing itself. That's because Massachusetts Financial has become a wholly-owned subsidiary of the Sun Life Assurance Company of Canada since the 1981 IRS ruling.
The annuities are probably best for people who already have individual retirement accounts (IRAs), but can afford to set aside more than the $2,000 annual limit, Mr. Costello said. ''With all the hoopla given to IRAs, with the $ 2,000 and all, it really isn't enough,'' he contends. ''When some people can make contributions to their own private corporate pension plans of $90,000 and $ 100,000 a year and when Keogh plans can put aside $15,000 a year, clearly $2,000 is not enough, especially for somebody who's 45 or 50 years old.''
For those who can afford to put aside more than $2,000 every year, these annuities are one long-term option.
Making sure they stayed a long-term option was one of the reasons Congress changed the tax treatment on annuities and stiffened the penalties on early withdrawals in the Tax Equity and Fiscal Responsibility Act. Under the new law, any money received from the annuity, except policy dividends, is treated as taxable income. In addition, there is a 5 percent penalty on withdrawals made before 10 years.
''The IRS saw what they perceived as an abuse of the annuity, the use of it for short-term tax deferral as opposed to long-term investment objectives,'' said Scott Logan, senior vice-president at Massachusetts Financial. ''We think the legislation is very positive. It clearly defines what you can do with it (the annuity).''
The new law ''makes the products much more secure . . . and gives the IRS what it wants,'' Mr. Costello said. ''Anybody who comes out early pays taxes on the income immediately, and you've got a 5 percent penalty on the income if you take it out before 10 years.''
''So while the products are on their face less attractive,'' he adds, ''they are better structured and better insulated from further crazy rulings.''
Even before the new law, Mr. Logan argues, most of these plans were sold for long-term investment goals. ''We always felt the borkers and agents selling the Spectrum-type annuities were selling it right. People buying it wanted long-term objectives.''
In addition to tax law changes and new IRS regulations, these products have brought on changes for the people selling them. ''The insurance agent is more and more getting training in selling stocks and bonds,'' Mr. Logan says, ''just as the broker is getting more training selling insurance products.''