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johnanglemen
Joined: 01 Oct 2009
Posts: 53
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 Posted: Mon Oct 12, 2009 12:09 am Post subject: Defered annuities: what's the catch? |
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| I'm a young/new investor who has maxed out his contributions to his 401k and has an additional six figures spread out across stocks and bonds. I just learned about deferred annuities tonight and I feel like I must be missing something, because they seem just like a limitless 401(k). Why would I not start putting a portion of my paycheck into a deferred annuity each month after I've maxed out my 401k contribution? |
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kaneohe
Joined: 22 Sep 2008
Posts: 725
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| Posted: Mon Oct 12, 2009 12:37 am Post subject: |
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| One thing that is different is that you don't get a tax deduction (or salary reduction) for your contributions as you do for a 401K. |
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tfb
Joined: 19 Feb 2007
Posts: 3215
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| Posted: Mon Oct 12, 2009 12:37 am Post subject: Re: Defered annuities: what's the catch? |
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| johnanglemen wrote: | | because they seem just like a limitless 401(k) |
I assume you are talking about a deferred variable annuity like the ones offered by Vanguard. They are actually like a limitless non-deductible IRA with a higher cost. The non-deductible part makes it less attractive than a 401(k), or maybe even less attractive than a taxable account for stocks, and the higher cost makes it less attractive than a real non-deductible IRA if you are not eligible for a Roth IRA.
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johnanglemen
Joined: 01 Oct 2009
Posts: 53
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| Posted: Mon Oct 12, 2009 1:20 am Post subject: |
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I'm not eligible for a Roth IRA and in any case I'm already contributing the max each year to a retirement account.
I'm in the top tax bracket right now. I understand that an annuity may not outperform efficient stocks in a taxable account, but is it worthwhile to use a portion of my 20% bond/"safe" allocation for an annuity or should I just stick to bonds (taxable in the 401k and tax-exempt in a taxable account)? |
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tfb
Joined: 19 Feb 2007
Posts: 3215
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| Posted: Mon Oct 12, 2009 1:48 am Post subject: |
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| johnanglemen wrote: | | I'm in the top tax bracket right now. I understand that an annuity may not outperform efficient stocks in a taxable account, but is it worthwhile to use a portion of my 20% bond/"safe" allocation for an annuity or should I just stick to bonds (taxable in the 401k and tax-exempt in a taxable account)? |
Bonds in a variable annuity (VA) cannot beat bonds in a 401k due to the extra cost in the VA. If you remain in top tax bracket when you withdraw after 59-1/2, bonds in a VA probably won't beat tax exempt bonds in taxable either because the reduction in yield on tax exempt bonds is often less than the top tax rate.
I suggest you get either Four Pillars of Investing or Intelligent Asset Allocator by William Bernstein. A lot of great asset allocation info there.
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Call_Me_Op
Joined: 07 Sep 2009
Posts: 115
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| Posted: Mon Oct 12, 2009 6:33 am Post subject: |
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There are other differences (which may not concern you) related to asset protection. Bottom line - they are not equivalent to 401K's.
-Op
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-Op
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dave.d
Joined: 19 Mar 2007
Posts: 704
Location: Richmond, VA
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| Posted: Mon Oct 12, 2009 3:16 pm Post subject: |
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Like a 401(k), if you hold stocks in a variable annuity you can magically convert capital gains into ordinary income, eligible for taxation at a higher rate. Plus, IIRC, any money that comes out of a VA is treated as taxable earnings first. These features of variable annuities always reminded me of the 2nd Dilbert cartoon here:
http://www.bylo.org/dilbert1.html |
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mephistophles
Joined: 27 Mar 2007
Posts: 1503
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| Posted: Mon Oct 12, 2009 4:22 pm Post subject: Re: Defered annuities: what's the catch? |
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| johnanglemen wrote: | | I'm a young/new investor who has maxed out his contributions to his 401k and has an additional six figures spread out across stocks and bonds. I just learned about deferred annuities tonight and I feel like I must be missing something, because they seem just like a limitless 401(k). Why would I not start putting a portion of my paycheck into a deferred annuity each month after I've maxed out my 401k contribution? |
It depends on what type of deferred variable annuity you are talking about? |
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grok87
Joined: 27 Feb 2007
Posts: 2814
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| Posted: Mon Oct 12, 2009 10:36 pm Post subject: |
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| johnanglemen wrote: | I'm not eligible for a Roth IRA and in any case I'm already contributing the max each year to a retirement account.
I'm in the top tax bracket right now. I understand that an annuity may not outperform efficient stocks in a taxable account, but is it worthwhile to use a portion of my 20% bond/"safe" allocation for an annuity or should I just stick to bonds (taxable in the 401k and tax-exempt in a taxable account)? |
If you are in a top tax bracket and out of room for bonds, you may want to consider municipal bonds. Vanguard has some good muni bond funds.
cheers,
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BruceM
Joined: 08 Aug 2008
Posts: 739
Location: Manzanita, Oregon
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| Posted: Tue Oct 13, 2009 12:18 am Post subject: Re: Defered annuities: what's the catch? |
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| johnanglemen wrote: | | I'm a young/new investor who has maxed out his contributions to his 401k and has an additional six figures spread out across stocks and bonds. I just learned about deferred annuities tonight and I feel like I must be missing something, because they seem just like a limitless 401(k). Why would I not start putting a portion of my paycheck into a deferred annuity each month after I've maxed out my 401k contribution? |
Its easier if you don't think of a deferred variable annuity (DVA) as an annuity. It is really a savings account to which contributions must be made with after tax dollars and
-growth, of any tax character, including capital gains, interest, dividends and investment distributions that are return of capital, are all tax deferred until withdrawn
-do not require that contributions are earned income and do not have AGI limitations
-all future withdrawals come out earnings first and are taxed as ordinary income. After the earnings are out, you will withdraw your contributions which are not taxed. If you annuitize the account, each monthly payment will be prorated between the basis and the earnings.
-any non-annuitized withdrawals before age 59.5 will be the untaxed portion first (taxed as ordinary income) and subject to the 10% early withdrawal penalty
-are not subject to minimum required distributions at age 70.5
and here's the kicker....
-may carry very high expenses
the last point is potentially the most important to you.
Let me put it this way....if you invested $10,000 into a DVA for a given year, and the expenses totaled $5,000 (50%), would you do it? Of course not.
How about expenses of $2,000? $1,000? $500? $1?
Well, if total expenses on the DVA were $1 you would do it...right? I would.
So somewhere between total annual expenses of $500 for this $10,000 contribution (5%) and $1 (.01% or 1 basis point), there is an expense that you would be willing to pay for the tax deferred growth of a DVA.
So the question is, what is this expense and how did you calculate it.
If you don't determine this, the odds are that your annual expenses will likely be close to 5%, which will represent somewhere around 60% of the DVA's long term earnings.
Are you willing to pay that?
I'm not.
BruceM |
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MossySF
Joined: 19 Apr 2007
Posts: 908
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| Posted: Tue Oct 13, 2009 1:21 am Post subject: |
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It may make it clear to show the math in detail. Let's compare the math against all the possible options IRA, Roth IRA and taxable with the following parameters: $1000 pre-tax contribution, 25% tax rate, 5% return, 10 year period.
IRA/401K
$1000 * (1.05 ^ 10) * 0.75 = $1221
Roth IRA/Roth 401K
$1000 * 0.75 * (1.05 ^ 10) = $1221
Taxable Zero-Turnover Stocks at 15% capital gains
($1000 * 0.75 * (1.05 ^ 10) - $1000 * 0.75) * 0.85 + $1000 * 0.75 = $1150
Non-Deductible IRA
($1000 * 0.75 * (1.05 ^ 10) - $1000 * 0.75) * 0.75 + $1000 * 0.75 = $1103
Low-Cost Vanguard VA at 0.25% extra ER
($1000 * 0.75 * (1.0475 ^ 10) - $1000 * 0.75) * 0.75 + $1000 * 0.75 = $1082
Taxable Bonds
($1000 * 0.75 * ((1 + .05*.75) ^ 10)) * 0.75 + $1000 * 0.75 = $1000
So it seems holding non-deductible IRAs and low-cost VAs could work for bonds if you've completely ran out of space in your 401K for your AA. REITs are also a possibility but the calculations are more complicated. The following spreadsheet at my blog can do all the above calcs and more:
http://personalbizfinance.com/....eet-1.html
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ilan1h
Joined: 22 Oct 2007
Posts: 610
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| Posted: Sun Nov 22, 2009 1:01 pm Post subject: |
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| MossySF wrote: | It may make it clear to show the math in detail. Let's compare the math against all the possible options IRA, Roth IRA and taxable with the following parameters: $1000 pre-tax contribution, 25% tax rate, 5% return, 10 year period.
IRA/401K
$1000 * (1.05 ^ 10) * 0.75 = $1221
Roth IRA/Roth 401K
$1000 * 0.75 * (1.05 ^ 10) = $1221
Taxable Zero-Turnover Stocks at 15% capital gains
($1000 * 0.75 * (1.05 ^ 10) - $1000 * 0.75) * 0.85 + $1000 * 0.75 = $1150
Non-Deductible IRA
($1000 * 0.75 * (1.05 ^ 10) - $1000 * 0.75) * 0.75 + $1000 * 0.75 = $1103
Low-Cost Vanguard VA at 0.25% extra ER
($1000 * 0.75 * (1.0475 ^ 10) - $1000 * 0.75) * 0.75 + $1000 * 0.75 = $1082
Taxable Bonds
($1000 * 0.75 * ((1 + .05*.75) ^ 10)) * 0.75 + $1000 * 0.75 = $1000
So it seems holding non-deductible IRAs and low-cost VAs could work for bonds if you've completely ran out of space in your 401K for your AA. REITs are also a possibility but the calculations are more complicated. The following spreadsheet at my blog can do all the above calcs and more:
http://personalbizfinance.com/....eet-1.html |
Mossy SF,
I took a close look at your site and your spread sheets. Thanks a bunch for making these valuable tools available to us. You seem to know an amazing amount about this stuff. Just out of interest, are you an accountant or a pension planning advisor? |
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kaneohe
Joined: 22 Sep 2008
Posts: 725
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| Posted: Sun Nov 22, 2009 4:01 pm Post subject: |
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| MossySF wrote: |
Taxable Bonds
($1000 * 0.75 * ((1 + .05*.75) ^ 10)) = $1084
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MossySF,
I agree .......very nice analysis of the various variations.
I'm having trouble understanding why the taxable bonds shouldn't be this tho......I couldn't figure out what the rest of the terms were doing. |
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