Variable Annuities vs. Mutual Funds: Which is Better?

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, June 25, 2000.

Copyright 2000  Robert L. Sommers, all rights reserved.

Part two of a two-part series

Variable Annuities vs. Mutual Funds: Which is Better?

Compared to mutual funds, variable annuities have several significant drawbacks: Besides no favorable capital gains treatment on distributions, there are estate tax disadvantages as well. While both a mutual fund and an annuity are included in an estate for estate-tax purposes, the beneficiary of a mutual fund pays no income tax on the fund’s appreciation prior to the decedent’s date of death.

Distributions to a beneficiary from a variable annuity will be taxed as ordinary income under the "income with respect to a decedent" rules. Thus, similar to an IRA, the variable annuity is subject to both an estate tax and an income tax, although there is an income-tax deduction (not a tax credit) for the portion of estate tax paid on the annuity.

Compared to an IRA or 401(k) investment, which are purchased with tax-deductible dollars, there is no tax deduction associated with the purchase of a variable annuity. A variable annuity and Roth IRA are both purchased with after-tax dollars and grow tax-free, but the Roth distributions are received tax-free, while annuity distributions are fully taxable as ordinary income.

A variable annuity has an expensive surrender charge if you decide to withdraw money from the contract during the first few years after purchase. Generally, the surrender charges apply to withdrawals before seven years. These charges are imposed to pay sales commissions. They can be as high as 7% in the first year, then usually decrease by 1% each year thereafter.

In addition to sales commissions, you typically pay 1.25% for the death benefit, plus administration fees charged by both the insurance company and mutual fund. Compared to a mutual fund’s administration fees, a variable annuity can be an expensive investment.

Because of the combination of high surrender charges, administrative fees and adverse tax consequences, many financial advisors claim that a direct investment in a mutual fund concentrating on long-term growth, such as an index fund that tracks the S&P 500, is superior to the performance of a variable annuity.

The insurance industry counters that stock investments are risky and many mutual funds generate short-term gains which are taxed as ordinary income. Thus, comparing the tax consequences between a mutual fund and a variable annuity is difficult. Note: With a variable annuity, investments can be moved between mutual funds with no tax cost, unlike a direct investment in a mutual fund.

For those considering these contracts, consider purchasing a "no-load" annuity offered by several major mutual fund operators. Currently, school teachers and college professors in the TIAA-CREF pension system have access to low-cost variable annuities — these products are now available to the public.

Annuities are best suited for those who: (1) do not have a retirement plan; (2) are willing to invest in the contract over the long-term; (3) will not need to withdraw money during the first seven years; (4) would not invest directly in the stock market; (5) will not be subject to estate tax (if their taxable estate is valued at $675,000 or less in 2000); (6) are concerned with having money during retirement, rather than passing wealth to beneficiaries at death; (7) have additional funds for emergencies; and (8) will be in a low income tax bracket (15% or 28%) when they receive their payments.

In conclusion, to get the best value from a variable annuity, you need to: (1) understand the complexities, administrative fees and hidden costs of the policy; (2) be in a low tax bracket at the time of distribution, and (3) live beyond the life-expectancy established for you at the time you begin receiving payments. As always, it is prudent to consult with an independent, fee-based financial advisor before making such a large investment.

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All contents copyright 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.