IRS delivers ‘game changer’ for fee-based annuities

Agency issued a private letter ruling to Nationwide indicating that pulling an advisory fee from the annuity doesn't create a taxable event.

The Internal Revenue Service has issued a tax ruling that may quickly boost the use of annuities by registered investment advisers with clients, by knocking down what many saw as the primary road block to their uptake.

The IRS furnished a private letter ruling to insurer Nationwide allowing RIAs to pull clients’ advisory fees from the cash value of a non-qualified fee-based annuity without any adverse tax consequences, which runs counter to the existing rules.

“That’s a game changer for fee-based annuities,” said Sheryl Moore, president and CEO of consulting firm Moore Market Intelligence. “That’s been one of the huge issues: People were concerned that if you take a withdrawal from the annuity to pay the adviser’s fee you create a taxable event.”

The tax rules addressed in the recent IRS ruling had created a conundrum for RIAs that are compensated with an annual asset-based fee rather than a commission. Pulling an adviser’s fee from a non-qualified annuity policy, which is sold outside a retirement account such as an IRA, counted as a taxable distribution for the client at ordinary income rates, as reflected on a 1099 tax form. Further, if the client were less than 59 ½ years old there was also a 10% penalty on the distribution.

The rules are different for qualified annuities sold in retirement accounts — the IRS allows advisory fees to be pulled from these annuities without tax consequence to the client.

The rules on non-qualified annuities were not only a nuisance for the client, but also effectively made the adviser’s advice more expensive. Advisers had workarounds, such as pulling the annuity fee from other client accounts. That had drawbacks, though, since it may have appeared to the client to dilute performance of those accounts. Advisers who didn’t manage other client assets also didn’t have this option available.

“This is a big win for RIAs and fee-based advisers,” Craig Hawley, head of Nationwide Advisory Solutions, said of the private letter ruling.

The ruling, issued Aug. 6, comes at a time when fee-based (also known as no-load) annuities have become more popular. Insurers sold $3.2 billion of fee-based variable annuities in 2018, up 42% from the year before, according to the Limra Secure Retirement Institute. They now represent around 3% of overall VA market share, double their share in 2016.

Insurers launched a slew of products in 2016 and 2017, around the time the Department of Labor fiduciary rule, now defunct, looked as if it would push more clients into fee-based arrangements. Insurers such as Jackson National Life Insurance Co. have recently made efforts to boost distribution of fee-only products.

There are caveats to the recent private letter ruling. For one, it technically only applies to Nationwide and its annuity products, but Mr. Hawley believes it will be “impactful across the industry” and may lead other insurers to seek a similar ruling.

Further, the advisory fee can’t exceed 1.5% of the annuity contract’s cash value. The fee must be taken only for management of the annuity contract, meaning an adviser managing other client accounts could not pull the fee for managing all those accounts just from the annuity, for example.