A potential client came to me to ask about a variable annuity that he was being pitched by a large mutual fund company where he had investments. They told him how low-fee it was (relative to other annuities, which isn’t saying much!), and all about the supposed ‘tax benefits’ that a high income person would benefit from.
Unfortunately for this mutual fund company, I can both do research and do math, and was quickly able to cut through this salesperson’s BS. Let’s see why you are always going to do better with a plain ‘ol taxable index fund vs an annuity, even if you’re in the highest income tax bracket in America. Yep, you heard me. Given the fees of any annuity I’ve ever seen, you will NEVER be able to beat the performance of an index fund in a plain vanilla taxable brokerage account. Avoid annuities like the plague!
Annuities will not save you money vs index funds in a taxable account
For the taxable index fund, let’s use the Vanguard Target Retirement Fund 2050. It has an expense ratio of 0.15% and a dividend yield of 1.5%, which is pretty typical for the overall US stock market in recent years. (2% has been more in line with history, but it doesn’t change the conclusions below if DIV yields were to rise to that number.)
The variable annuity, on the other hand, has fees totaling at least 0.90%: a 0.25% ‘annuity fee’ and an underlying mutual fund with a 0.65% expense ratio. There are almost assuredly other sneaky fees that I didn’t need to look up, since the 0.9% expense ratio alone will tell us the taxable index fund is better.
Annuity salespeople will tell you that (non-retirement/post-tax money) annuities are tax-deferred, meaning you don’t pay dividend or capital gains taxes while they grow. This is true, but tax-free growth is not enough to overcome the greater annuity fees, not too mention other tax problems that annuities create when you go to cash them out.
Since you have to hold an annuity until age 59.5 to avoid the 10% penalty on the earnings distributed before then– another downside of annuities vs taxable accounts– it’s fair to assume you let the index fund grow and never pay any capital gains on it. So, your annual ‘tax fee’ for the index fund = 1.5% dividend yield * 23.8%, the highest possible dividend rate of 20% (as of writing) + the 3.8% net investment income tax (NIIT), which = 0.357%. Add that to the 0.15% expense ratio and you have an annual cost of 0.51%, nearly half the lower-bound 0.9% annual annuity expenses.
Annuities are taxed at income rates vs lower capital gains rates for stocks
Yep, so much for tax advantages while the money grows! It gets even worse for annuities when you cash them out. What the annuity salespeople DON’T tell you is that annuity gains are taxed at regular income rates vs much lower capital gains rates for stocks in a taxable brokerage account. (Of course, if you’re not already maxing out your retirement savings like your 401k or IRA, do that first before investing in a taxable brokerage for (early) retirement!)
So, not only did your annuity grow slower than your index fund after fees and (index fund) taxes, you’ll then pay 39.6%– if Biden gets his way and you’re in the highest tax bracket– for income taxes on the annuity vs 23.8% for the capital gains + NIIT on the index fund. (The math is similarly in favor of index funds in a taxable account for lower or middle income people.)
Even if dividend rates were set equal to income tax rates, the most you’d pay for the index fund would be 0.15% + 1.5% * 39.6% = 0.74%, still below the 0.90% in our example (and most annuities charge closer to 2%.)
If you really wanted to reduce your taxable dividends to pay even less on your index fund you could do something fancy, but personally I would just stick to the simple investment plan and eat the low taxes and avoid generating capital gains as much as possible.
I used to say that 99% of people should NOT buy an annuity. I’m updating that to 100%.
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Can anyone refute my logic and math with a real-life example?
Do you know of a really low-fee annuity, or some other circumstances, that gives a counterexample with the annuity coming out better? If so, I’d love to hear about it in the comments! Please note that I intentionally left aside the ‘minimum guarantees’ and return/participation rate caps that shady annuity peddlers also push as ‘benefits’ but almost always work out against the investor and (surprise surprise!) for the insurance company pushing the annuity product.