Tax-Advantaged Investing: Comparing Variable Annuities and Mutual Funds

By Toolson, Richard B. | Journal of Accountancy, May 1991 | Go to article overview

Tax-Advantaged Investing: Comparing Variable Annuities and Mutual Funds


Toolson, Richard B., Journal of Accountancy


As part of the financial planning process, CPAs can provide valuable input to help clients select the appropriate combination of investment vehicles to achieve the client's financial goals and objectives. Both variable annuities and mutual funds merit consideration. When choosing between a variable annuity and a mutual fund, investors need to carefully define their financial goals (such as retirement fund, child's education, long-term growth) and choose the vehicle which best meets those goals.

Because of the CPA's close financial relationship with the client, he or she is in a unique position to help the client determine his goals. An understanding of these goals, along with the CPA's knowledge of the client's tax situation, means the CPA is well suited to help the client choose between these two important investment alternatives.

ALLOCATING INVESTMENT DOLLARS

Variable annuities and mutual funds often compete for the same investment dollars because, like a "family" of mutual funds, a variable annuity allows the holder to invest in a similar range of professionally managed securities portfolios. This article compares investments in nonqualified variable annuities with mutual funds by examining, under different assumptions, the holding period necessary to generate the same after-tax accumulation.

With a variable annuity, the contract holder/annuitant is typically offered investment options similar to those of a mutual fund family. Offerings normally include a money market fund, one or more stock funds and one or more bond funds. Like mutual funds, payments or premiums to fund variable annuities may be paid either as a lump sum (single premium deferred annuities) or in installments flexible premium annuities).

With a variable annuity, the investment risk is borne by the annuitant and not the insurance company. Consequently, like mutual funds, the cash value of the annuity is linked to the performance of the annuity's underlying investments. With either an annuity or a mutual fund, the participant bas the right to withdraw the accumulation at any time but with different consequences. Variable annuities are held in separate accounts, not in the insurance company's general account. This means these monies, like monies invested in mutual funds, are not part of the balance sheet of the company and cannot be used to satisfy its debt obligations.

With the effective elimination of traditional tax shelters as a result of the Tax Reform Act of 1986, insurance companies have promoted annuities as one of the few remaining tax shelters. Promotional literature typically compares a hypothetical investment in a tax deferred annuity with one in a taxable investment (such as a mutual fund). The assumption is that both the tax-deferred annuity and the taxable investment earn the same rate of return, and earnings from the taxable investment are taxed each year at a maximum rate.

A chart in the marketing brochure typically illustrates accumulations over periods of 10 to 30 years with the predictable result: The tax-deferred accumulation significantly exceeds the accumulation of the taxable investment, particularly over longer periods of time. This illustration, however, fails to consider several variables, any of which could significantly reduce the tax-deferred accumulation. These variables include the taxability of annuity earnings upon distribution, the 10% premature withdrawal penalty for distributions before age 59 1/2 and contract fees. When these factors are taken into consideration, the investor may be worse off investing in a variable annuity than in a mutual fund whose earnings are taxed annually.

FEE CHARGES

In order to compare variable annuities with mutual funds, it's necessary to compare the fees charged annuity contract holders with those charged mutual fund shareholders. As of May 1, 1989, the Securities and Exchange Commission, which regulates variable annuities as well as mutual funds, requires full disclosure at the beginning of an annuity prospectus of all expense charges imposed on an annuity holder. …

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