If you are thinking of starting a variable annuity that you will invest in stocks, you will do significantly better if you just invest the money as a regular post-tax stock investment, assuming you do not trade more than once a year. But if it is money that you want invested in bonds, the variable annuity can be advantageous if it has a low excess annual expense charge and you have a tax rate at least 28%. A variable annuity is in all respects worse than even a nondeductible IRA, strictly as a way of saving for your retirement.

How A Non-Deductible IRA Works

If you have maxed out your 401k or similar employer plan and make too much to contribute to a Roth IRA, you should generally put up to $2000 a year in a non-deductible IRA. This means that you do not get to deduct the contribution from your income taxes, but all taxes on earnings are deferred until you cash it in. This is a strong advantage for bond investments. But it usually takes several decades for equity investments before this advantage of tax deferral outweighs the disadvantage that capital gains on a regular post-tax account are taxed at a lower tax rate -- around 30 years at the 44% tax rate, around 20 years at tax rates below 33%.

Each time you take money out of a non-deductible IRA, you only pay taxes on a part of the withdrawal. You calculate the total of all non-deductible contributions over the years, and divide that by the total current value of ALL ordinary IRAs (non-deductible, deductible, and rollovers). That ratio tells you the percentage of the withdrawal that is not taxed. You cannot withdraw just the "non-deductible" part. There is usually a 10% penalty on withdrawals before the year you turn 59.5.

This may not sound all that great, but a variable annuity (discussed next) is worse. A variable annuity has an excess annual fee which can easily take 10 to 25% of your total investment over several decades. Note, however, than any dividends or other distributions paid within an IRA or variable annuity remain inside it and thus do not incur any taxes at that time. Nor do you have to worry about taxes when you make a direct "trustee to trustee" transfer from one company to another. You pay taxes only when you make a withdrawal for spending.

How A Variable Annuity Works

A variable annuity is an investment vehicle in which you put after-tax money, let it grow with no paying of taxes until you are at least 59.5 years old, and then pay taxes on any of the earnings you take out. Taxes are paid at ordinary income tax rates, up to 39.6% for federal tax and some additional for state tax. You do not get the benefit of the reduced capital gains tax rate. If you take out only part of the variable annuity, it is all taxed as earnings until the amount left is no more than what you contributed; thereafter, withdrawals can be tax-free (since they are a return of your contribution). You have to either cash it in or convert it to a lifetime schedule of payments by the age of 90. If you establish a lifetime schedule of payments, they are treated as partially earnings and mostly as return of principal for tax purposes, which greatly lowers the taxes owed.

95% of variable annuities have an excess annual expense fee of over 0.8% per year. This is in addition to the normal expense charges of the mutual fund. This excess expense charge is highest for a variable annuity that is sold by salesmen that you talk to in person, since it covers the sales commission (the load). And moreover, these variable annuities usually have a clause saying you cannot take your money out for 7 years or so, or at most 10% of it each year, or the like.

The best-priced variable annuities are sold over the phone; but of course you will not receive investment advice with such purchases. The lowest prices for generally-available no-load variable annuities are currently around 0.48% for Vanguard, 0.55% for T. Rowe Price and 0.81% for Fidelity (for excess annual expenses). Educators can get variable annuities from TIAA-CREF for an excess expense cost of only 0.20% annually.

A variable annuity has a minor insurance feature: If you die when its value is less than what you put in, your heirs get back all of what you put in. This feature is not worth too much, because since the 1930s the general stock market has never lost dollar value over any 12 year period. In any case, it is not a benefit to you for your retirement income, only to your heirs.

By contrast, bank CDs in a tax-deferred annuity rarely have a significant excess charge, because the loss insurance is superfluous. So if you have extra cash that you do not expect to need in retirement, it can be advantageous to use a bank CD tax-deferred annuity to avoid bothering with taxes for several decades. And if you die before age 90, you don't have to bother with the taxes at all; your heirs can do that.

Don't Buy Long-term Stock Investments In A Variable Annuity

Assume Sam and Bob each have some post-tax money that they do not need until after age 59.5. Bob puts his money in a variable annuity with a 1.2% excess annual expense charge, and Sam puts his in a regular post-tax stock account with low distributions that he does not trade more than once each twelve months (an indexed or tax-managed fund would be best). Both reinvest all distributions, except for what Sam uses to pay the current taxes on the distributions. Some years later (after age 59.5), they each cash the investment in, pay all taxes due from the proceeds, and spend the rest. If they have roughly the same investment results, then it is easy to see why Bob loses in every single case, even without using a spreadsheet or calculator.

1. On the dividend part of the earnings, Bob pays 1.2% in excess fees, in addition to the normal expenses of mutual funds. Sam pays less than 1.2% of total value in income taxes, since distributions should be less than 3% of total value. Clearly Bob pays more than Sam pays in the years before the investments are cashed in; thus Bob has the lower balance at withdrawal.
2. When Bob cashes in his variable annuity, he pay taxes on all of his dividends and the growth on those dividends, but Sam pays taxes only on their growth; his dividends have already been taxed.
3. Sam's deferred capital gains on the stock will be taxed at 18 to 20% but Bob's will be taxed at 28% or higher. If the two have dropped down to the 15% rate when they cash in, Sam will pay only 8 to 10% tax on the deferred capital gains but Bob will pay 15%.
4. If they die before they cash in, then Bob's heirs pay that income tax but Sam's heirs generally do not (due to the step-up in value for inherited stock investments).

In sum, Sam's taxes are clearly far less than Bob's taxes plus excess expenses. You don't need a spreadsheet to see this. SAM COMES OUT WAY AHEAD OF BOB.

However, a variable annuity tends to produce a savings for stock investments when the federal tax rate is 28 to 31% and either (a) you trade more than once a year, or (b) the stock investment has very high annual distributions. This is because you do not get the lower capital gains tax rate.

Of course, another way that a variable annuity is better is if it is invested in a mutual stock fund that can be reliably expected to outperform the S&P500 by at least 1.2% annually in the future. There are some that have outperformed in the past, but can you be sure they will continue to do so? Surely you wouldn't believe a salesman who guarantees you he has such a fund...would you? :-)

Should You Buy Bond Funds In A Variable Annuity?

For bond funds and guaranteed-interest contracts, the situation is better. Say the pre-tax return on the bonds is 6%. In a regular investment at the 32% combined tax rate you keep only 4.1% after taxes. In a variable annuity with a 0.5% excess expense charge, you keep almost 5.5% but you owe income tax when you cash in. It would take 9 years for the variable annuity to overcome that disadvantage at the 44% tax rate, 13 years at the 32% tax rate, or 30 years at the 17% tax rate. But if the variable annuity has an excess expense charge of 1.2%, it would take 29 years at the 44% rate and much longer at lower tax rates.

In particular, a person at the 15% federal tax rate would always be better off for retirement income using a regular post-tax account rather than a variable annuity unless it is a no-load annuity held for over 30 years, or it is a guaranteed-interest contract. And in the latter case, you should make sure it pays better than the FDIC-insured tax-deferred bank CD.

You might argue that this logic is flawed because the money in a variable annuity is withdrawn over a large number of years rather than all at once. But that just means that the several thousand you withdraw in the first year at 15% loses, the several thousand you draw the next year loses, the several thousand you draw the third year loses, and so on.

A variable annuity has a special advantage if your combined federal+state tax rate drops from 32% to 17% in the year in which you cash in the variable annuity. Then it will only take 10 years to overcome the disadvantage at a 1.2% excess annual fee, 3 years at a 0.5% excess annual fee. Of course, different interest rates, different tax rates, and different expense charges affect this result. But a reasonable generalization is that a bond investment in a low-priced variable annuity will pay off significantly in less than 10 years IF your federal tax rate in retirement is 15% and IF it is at least 28% during the period that you hold the variable annuity and IF you cash it in very soon after your rate drops.

Look Into Fixed Life Annuities

A variable annuity has the strong advantage that you can arrange to have it give you higher income for life as a fixed life annuity. For instance, when intermediate bond interest rates are around 5 to 6%, you can get a lifetime fixed income of 10 to 12% at age 70, though your heirs do not get anything (unless you choose an X-year-certain option, which reduces the payout slightly).

Moreover, you can arrange to have the payout increase by a fixed 3% each year, which partially compensates for inflation. You will, however, have to accept about 25% less initially. For instance, a single-life fixed annuity costing $200,000 might pay out $15,000 to $18,000 annually starting at age 70, rising 3% annually to around $30,000 to $36,000 annually by age 94.

The following is just one example: As of December 1998, a $100,000 payment to Fidelity will give an age 70 single male $853 monthly for life, which is 10.24% annually. If he wants the 10-year-certain option, so that his heirs continue to receive the payments until his age 80 if he dies before age 80, he would get $796 monthly, which is 9.55% annually. A married couple both age 70 would receive $690 monthly (8.28% annually) with the 10-year-certain option (so payments continue as long as either is alive and until age 80 in any case).