By: Frank Armstrong, CFP, AIF
It’s just about impossible to build a case for annuities that makes economic sense. The most widely sold variable annuities have total annual expenses close to 3%.Contrary to most sales literature, the taxation of annuities is not favorable when compared to a reasonably tax efficient mutual fund. But don’t take my word for it. See for yourself.
To fairly compare an annuity and a mutual fund, the after-tax (post withdrawal) values must be considered for each. After all, it’s what you can spend after the taxes are paid that matters. What we find is that the tax treatment on distribution is so bad that even if the annuity wrapper were free you wouldn’t want it.
To illustrate just how bad annuities are, I’ve prepared a spreadsheet that models both mutual funds and variable annuities. However, there are a few points not included in the model that make annuities even worse:
- Early surrender fees
- Premature distribution tax penalties
- Loss of step up in basis at death
We presume that the investor is faced with a simple choice for a taxable account: either he buys a no-load mutual fund, or he buys the same fund inside an annuity.
Our example compares an average mutual fund against the average variable annuity. Had we chosen to compare a no-load index fund against a variable annuity, the results would be even more lop sided against the annuity. And, of course, that is the approach I would strongly suggest investors take.
Conclusion: Just say no to variable annuities! The loss of capital gains treatment and additional annuity expenses eat up more than the benefit of deferral in almost any reasonable case you can make up.
I have loaded some sample data for you. But, feel free to enter your own. You can’t hurt a thing. You may want to print out these instructions as you play with the examples. Here is how to enter the data to make your own comparison:
If you don’t have Excel you can download Excel 97/200 Viewer here)