Magazine article The CPA Journal

Mutual Funds, Variable Annuities, and Direct Ownership

Magazine article The CPA Journal

Mutual Funds, Variable Annuities, and Direct Ownership

Article excerpt

As many baby boomers start to face the reality of saving for their retirement, they may find it necessary to consult a financial planner concerning the need to accumulate more funds for retirement than they are saving in Keogh, 401(k), or other tax-sheltered retirement plans.

Investment in common stock through mutual funds, variable annuities, or direct ownership is usually considered by most investment counselors and financial planners to be the most appropriate means for building funds for retirement. Savings accounts, money market funds, and the investment of bonds have historically not generated the same long-term rate of return as common stocks. Aside from owning a home, real estate should not be seriously considered by neophytes. This is mainly due to the lack of liquidity and risk related to changes in the local economy.

Thus, an investor's primary focus should be in making the right investment choices in common stock. An analysis of investment in mutual funds, variable annuities, or direct ownership of common stocks shows that each alternative has merits, depending on several factors that should be examined closely. This analysis assumes that the taxpayer is already taking advantage of all tax-sheltered retirement plans and is seeking an analysis of stock ownership choices made with after-tax dollars outside of retirement plans.

THE INVESTMENT PROCESS

Choosing the right investment vehicle for common stock is a three step process. The first step is to gain an understanding of how the major cost factors (transaction costs, income taxes, and capital gains taxes) affect each investment differently. The second involves analyzing personal and financial attributes to determine which investment vehicle would be best under the circumstances. Finally, the third step is to develop a strategy regarding the selected investment vehicle to maximize the potential, long-term rate of return.

How the same three cost factors reduce the rate of return for each investment vehicle alternative is shown in Table 1. (Table 1 omitted) The initial investment of $2,000, and the accumulated sum from compounding at a 10% rate of return over a 20-year period are shown in the first two rows of Table 1. These figures are often used in advertisements to promote investing in mutual funds or variable annuities. Often omitted from the advertisements is the fact that the accumulated sums have not been reduced by the costs related to each investment vehicle.

Transaction Costs. The first cost factor (transaction costs) will vary significantly with each investment vehicle. An investor should estimate what percentage of capital will be used each year to pay brokerage commissions for direct ownership of common stock, sales fees and operating costs for mutual funds, and sales fees, operating costs, and the cost of the annuity contract for variable annuities. The after-transaction-costs return in Table 1 reflects a "buy and hold" strategy for direct ownership of common stock and the average cost for mutual funds and variable annuities.

Income taxes. The second cost factor will have the largest effect on the returns of mutual funds. Mutual fund investors usually pay the highest income taxes since most mutual funds have high portfolio turnover resulting in higher taxable income. The holders of a stock portfolio would pay taxes on cash dividends and any net gains from sale of securities. Table 1 assumes a 33% income tax rate. No income taxes would be paid by the investor in a variable annuity.

While taxes can be deferred, they must eventually be paid. Table 1 assumes the taxpayer will want the accumulated funds at retirement and shows the reduced after-taxed return on the disposal of both the variable annuity and the stock portfolio. The 10% penalty tax imposed on the variable annuity holder who withdraws his or her funds before the age of 59-1/2 is not included in the figures.

Table 1 also shows that the stock portfolio will provide the highest real rate of return after inflation. …

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