Posted on March 6, 2015 in ,

Why Tax-Efficient Funds Beat the Benefits of Annuities

By CHAS P. SMITH, CPA/PFS and Derek M. Oxford

Excerpts Published Thursday, March 5, 2015 by Lakeland Ledger

Non-qualified (non-retirement plan) variable annuities allow investors to stash an unlimited amount of cash for retirement.  Also, that money grows tax-deferred until you withdraw it.  Funds invested in variable annuities are insurance products and may be creditor proof in some states. Annuity contracts do have the advantage over mutual funds to defer income taxes until withdrawals occur.  You can switch portfolio allocations, rebalance your account, or even conduct a 1035 exchange from one annuity to the other without paying any taxes at all.   Variable annuities (VA) are one of the fastest-selling investment product on the market.  It’s no mistake why these insurance products seems so enticing to investors.

However, there are four main issues with variable annuities which make them unattractive for most investors.  The first is the exorbitant internal expense ratio which on average is 2.11% annually compared to the average index mutual fund of 0.18% annually.  These high fees directly reduce the investors’ net return.  The second issue is the huge surrender charges (used to pay the broker’s commission) if the investor wishes to liquidate his or her investment before the end of the contract period which average five to seven years. The broker that sells these products rarely discuss these charges which are fully disclosed in the voluminous contracts.  Third, if you are lucky enough to have gains in these variable annuity contracts the gain is taxed at your highest tax rate (ordinary income) versus long term (one year) capital gains from mutual funds which are taxed at much lower tax rates.  Fourth, heirs will not receive a step up in basis on the annuity’s value including any gain whereas inherited mutual funds are transferred to heirs at the market value at the date of death.

Consider investing $100,000 in a VA earning 10% annually for 20 years, but charging 2.11% in expenses annually.  Your annuity grew to $456,692 after that period. If you withdrew the entire annuity your after tax amount would be $315,442 assuming a 39.6% tax rate. The after tax annualized return of the annuity is reduced to 5.9%.   The same amount invested in a tax-efficient index fund or ETF that earns 10% and generates a tax liability of .22% and incurs fees of 0.18% grew to $625,477.  With the index fund, gains are taxed using capital gains rates, which assumes the highest tax bracket of 20%.  After cashing in the mutual fund and paying the capital gains tax you’re left with $520,382, or an annualized return of 8.6%.  That’s a difference of $204,940 to spend during retirement!

If annuities don’t seem to be the product for you, consider using one of the no-load mutual fund companies that offer an array of low cost index funds and tax efficient ETF’s (exchange traded funds).  The three low cost companies are Fidelity Investments, Vanguard Group, and iShares by BlackRock.

Source: Dow Jones & Company, Inc.

Next time:  Women and Social Security: How to Get the Maximize Benefits

Chas P. Smith, CPA/PFS is president and chief investment officer of CPS Investment Advisors.  Derek M. Oxford, Portfolio Analyst at CPS Investment Advisors, is a contributing author of this article.