SAVING FOR RETIREMENT Don't Let the Bells and Whistles Distract You by Kimberly Lankford
Although variable annuities can
pay off in very limited circumstances (discussed below), most investors will do better
buying and holding mutual funds outside rather than inside this tax shelter.
Transforming capital gains to ordinary income is harder to justify.
The widening gulf between the regular tax rates -- as high as 35% -- that ultimately
apply to annuity earnings and the 15% rate for profits from straight mutual funds means it
takes longer for the benefits of tax deferral inside the annuity to overcome the loss of
capital-gains treatment.
Fees are much higher than for mutual funds. A few companies, including
Fidelity and Vanguard, have cut fees, but the average variable annuity still charges
2.09%, according to Morningstar. That's $2,090 each year on a $100,000 account. The
average mutual fund claims 1.4%.
The death benefit isn't worth the money. A large chunk of the fees
pays for the death benefit, which typically pays off only if you die when your account has
fallen below the minimum guarantee. But chances are slim that you'll lose money over the
long haul.
Bill Klipp, president of Charles Schwab Investment Management, points out that
"there are far cheaper ways to insure against an event of that sort." Consider,
for example, that the average annuity charges 1.11% per year primarily for this death
benefit -- $1,110 per year on a $100,000 account. Yet a healthy 60-year-old man would pay
about the same amount -- $1,100 a year -- for a $200,000 20-year level-term policy, which
would provide his heirs protection that would in no way be connected with the market.
You don't need a variable annuity to guarantee income for life. One of the most
frequently promoted but seldom-used benefits of annuities is annuitization -- which
guarantees you set payments for the rest of your life, no matter how long you live. The
reason annuitization is relatively unpopular is that it is inflexible: Once the payments
begin, you can't change your mind. Much more common is systematic withdrawal of funds,
which allows you to decide how much to withdraw at any time. You don't get the
lifetime-payments guarantee, but neither do you guarantee that payments end with your
death (or the death of a survivor if you choose a joint annuity). With systematic
withdrawals, your heirs get what's left in the account when you die.
If lifetime payments are important to you, realize that you don't need a variable
annuity to get them. You can invest in stocks or mutual funds until you're ready to start
tapping your nest egg, then sell them and use the proceeds to buy an immediate annuity.
Yes, you'll have to pay tax on capital gains at that time, leaving you less to invest in
the annuity. But because only after-tax money goes into the annuity, less of each payment
you receive will be taxed than if you had built up your account inside a tax-deferred
annuity.
You need to hold an annuity for at least 15 years. It takes at least a decade and a
half for the benefits of tax deferral to make up for the higher taxes and fees. The
break-even point depends on your tax bracket, the fees, whether you withdraw the money in
a lump sum or gradually over the years, and what you're comparing the annuity with --
particularly, how often you trade taxable mutual funds and how well they perform.
Beware of sales pitches that show a closer break-even point. They're probably based on
an assumption that if you buy mutual funds, you'll trade frequently and invest in funds
that make significant capital-gains distributions each year. Such assumptions stack the
deck in favor of annuities and ignore the advantage of tax-deferred growth, which is yours
if you buy and hold funds that make relatively small year-end distributions. That's
important because when funds pay out their gains, you have to pay taxes on your share. As
gains build up inside a fund, though, you get the same tax-deferral benefit you would
inside an annuity and the benefit of a 15% capital-gains rate when you do sell.
"Why pay the cost of a variable annuity just to get tax advantages when you can
invest in long-term-growth funds with few or no year-end distributions -- in effect,
converting ordinary income to capital gains?" asks Ricky Grunden, a financial planner
in Dallas.
In most scenarios, you'll end up about even if you buy a
variable annuity or a mutual fund, hold it for 15 years and withdraw a lump sum. Beyond 15
years, the variable annuity begins to pull ahead, particularly if you plan to withdraw
some money each year and leave the rest inside the tax-deferred account.
If you invest $100,000 in a variable annuity or mutual fund at age 50, for example,
then withdraw the money between ages 65 and 90, you'll receive $379,000 with the variable
annuity versus about $341,000 with the mutual fund -- assuming your investments return 8%
per year and your tax bracket drops in retirement. (If your bracket
doesn't drop, the advantage of the annuity does.) If you invest at age 40 and make
withdrawals between ages 65 and 90, you'll get $684,000 from the variable annuity versus
$543,000 from the mutual fund.
GETTING STARTED
