Investors often turn to certain kinds of investments only to discover strict and often expensive tax implications. One deferment solution for some investments may be a private placement variable annuity (PPVA), in which an investor contributes cash to an annuity contract that’s then invested in fixed-income and alternative strategies. But it’s not for everyone.
A typical investment allocation for investors is to bonds and, more increasingly, alternative investments such as private equity and hedge fund investments, said Michael Donahue, a CPA and partner at Drucker & Scaccetti in Philadelphia. “As effective as these allocations may be to your investment strategy, they have painful tax implications due to high-income tax rates on interest income and non-deductibility of investment fees,” he said.
A wealthy investor can use a PPVA to defer taxes. The investor contributes cash to an annuity contract, which is then invested in fixed income and alternative strategies.
Variable annuities have acquired a reputation for high costs and complexity. But a PPVA policy, sometimes referred to as an “investment-only annuity,” can work for some investors, Donahue said. For the cost of a small annual annuity fee (half of 1%), an investor defers taxability to the date they take cash out of the policy.
Since the investment fees decrease the underlying investment value, these fees become, in fact, deductible. Additionally, it is possible that the payments out of the annuity occur when the investor retires and resides in a no- or low-tax state, Donahue said. Tax rates in retirement are also frequently lower than at other times of life.
This tax-deferral tool isn’t for everyone. “A PPVA is usually an investment structure we see for high-net worth clients, usually because of the cost to set up, minimum investment sizes and level of sophistication needed,” said Rob Cordasco, a CPA and founder of Cordasco & Company in Savannah, Ga.
“The way I usually explain a PPVA is to think of it like any other variable annuity on the market, except you get to have more input on the terms of the variable annuity structure and more control over the investments held,” Cordasco said.
If properly set up, a PPVA is taxed in the same manner as any other variable annuity. “The downside, as with any variable annuity, is that there are penalties for withdrawals before age 59½ and the income is subject to ordinary income tax rates as opposed to capital gains rates,” Cordasco said.
According to the IRS, most distributions from qualified retirement plans and nonqualified annuity contracts made to you before you reach age 59½ are subject to an additional tax of 10%. This tax applies to the part of the distribution that you must include in gross income. It doesn’t apply, however, to any part of a distribution that is tax free, such as amounts that represent a return of your cost or that were rolled over to another retirement plan.
“A PPVA does open up a lot of doors for investments in assets that would generate ordinary income, like interest from bonds,” Cordasco said. “Additionally, a PPVA can be coupled with estate and trust strategies to really supercharge the tax benefits.”
Some observers have said this option also works well for foreign investors and even tax-exempt institutions that can still find themselves hit with a tax bill for income unrelated to their primary purpose.
The PPVA tool isn’t without other complications. “It is almost impossible to talk about PPVA without talking about private placement life insurance (PPLI),” Cordasco said. “PPLI is the life insurance version, so it’s more complicated, more expensive and requires a higher investment. As both variable annuities and life insurance have a place in someone’s financial profile, so do private placement vehicles.
“Again, since the barriers to entry are relatively high, these vehicles are usually only available to high-net-worth individuals,” he added.