NCPA - National Center for Policy Analysis

Taxable Mutual Funds Beat Tax-Deferred Annuities

November 21, 2001

Many people saving for retirement invest in index funds based on broad stock market indices, such as Standard & Poor's 500 stock index. Investors pay income taxes on dividends and capital gains distributions as they go, allowing them to withdraw funds with no additional tax during retirement.

Alternatively, they can purchase variable annuities, which defer taxes on earnings until they are withdrawn. (Unlike traditional annuities, which pay a fixed income monthly for life or set term of years, returns on these annuities vary with the performance of stocks.)

However, the after-tax return of mutual funds still outperforms tax-deferred variable annuities, according to financial writer Scott Burns of the Dallas Morning News.

Variable annuities have been heavily marketed in recent years. But only 111 variable annuity domestic equity sub-accounts have been available for 15 years or more -- the time required for tax deferral to really aid investment growth. Comparing these 111 variable annuities to the Vanguard 500 index fund:

  • In the three years ending Sept. 30, the averaged return on the variable annuities was 0.87 percent, which the Vanguard fund beat with 2.05 percent return.
  • At five years the spread is still harsh -- 6.15 percent for the 111 funds compared to 10.2 percent for the Vanguard 500 index fund -- again, even if you paid full taxes, you'd be better off with the taxable investment.
  • At 10 years the spread is smaller, 9.46 percent a year for the annuities compared to 12.61 percent for the pretax return of the taxable investment -- whose after-tax return declines to 11.56 percent a year. Only 16 of the 111 sub-accounts did better than 11.56 percent.Note that the index fund is taxed at the 20 percent capital gains rate while the deferred investment will be taxed at ordinary income tax rates, which can be much higher

Source: Scott Burns, "Variable annuities still prove taxing," Dallas Morning News, November 20, 2001.


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