“It is true that TIAA-CREF has very low cost annuities,” writes Richard Toolson, Associate Professor of Accounting, Washington State University. “However, as you’ve pointed out, they are only available to college and private school educators. Vanguard, however, does offer a pretty good spectrum of funds at what I believe to be rock bottom expenses. They are absolutely no-load (no back-end or front-end charges) and the insurance portion carries an expense ratio of just 27 basis points + 10 basis points for administration. Their total annual charges (including the mutual fund charges) are less than the annual charges for the vast majority of mutual funds. For somebody in a tax bracket of 28% or higher with a long term holding period (at least 10 years), who doesn’t need the money until after the age of 59.5 years, their annuities make economic sense. This is especially true for their annuities whose return is principally composed of mostly large amounts of ordinary income such as their REIT fund or High Yield fund. (I have run the breakeven periods on these and they make sense for a certain group of investors.)”

Well, the good thing with annuities is that their growth is tax-deferred, which means you get “the government’s” share of the appreciation working for you until you withdraw the money. The bad thing is that when you do withdraw the money, gains that would otherwise have gotten favorable tax treatment are all subject to ordinary income tax. So annuities are actually a machine that converts lightly taxed long-term capital gains into more heavily taxed ordinary income. (Who wants a machine like that?)

The 10-year period to which the good professor refers is roughly the time it takes for the tax-deferred compounding to make up for having to pay ordinary income tax on your gains at withdrawal. (The actual break-even point will vary from case to case depending on the actual investment results and on your tax bracket each year and at withdrawal.)

Vanguard’s low fees certainly help. But an alternative is simply to buy and hold stocks directly. When you do that, tax on the gains (though not the dividends) is deferred just as with an annuity; there are no expense charges; and gains when you eventually take them get the long-term tax treatment (or may even pass to your heirs free of capital gains tax altogether). So you get much of the deferral everyone covets without expense fees or giving up the favorable tax treatment of long-term gains. The same holds true buying an index fund, except that a small expense fee is charged.

 

Comments are closed.