New IRS Ruling is a 'Game Changer' for Fee-Based Annuities

A new tax ruling issued by the Internal Revenue Service may boost investment advisers’ use of annuities with their clients. The ruling removed an obstacle, which many saw as the primary roadblock to their uptake.

Running counter to the existing rules, 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 negative tax consequences.

Sheryl Moore, president and CEO of consulting firm Moore Market Intelligence, called the move “a game changer for fee-based annuities.” Adding, “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 IRS ruling had created a quandary for RIAs who are compensated with an annual asset-based fee instead of 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. Making things even more challenging was a rule that made clients under 59 ½ years old pay 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 effectively made the adviser's advice more expensive. In the past, advisers had tried to work around these constraints by pulling annuity fees from other client accounts. That had drawbacks, however, because it may have appeared to the client to dilute performance of those accounts. And for advisers who didn't manage other client assets, that wasn’t even an option.

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

Issued August 6, the ruling comes at a time when fee-based annuities have become more popular. According to the Limra Secure Retirement Institute, insurers sold $3.2 billion of fee-based variable annuities in 2018, up 42% from the year before. 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.

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

Furthermore, 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.


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