From a tax perspective, you can think of a tax-deferred variable annuity as similar to a nondeductible IRA. You won’t get an initial tax deduction, but you do get tax-deferred growth.
Problem is, unlike a nondeductible IRA, you can’t convert a variable annuity to a Roth IRA. On top of that, a variable annuity gives you much less investment choice and you’ll face much higher expenses. Within an annuity, you get to choose from among a series of subaccounts that are similar to mutual funds. Each subaccount has its own investment expenses.
Layered on top of that is the expense of the variable annuity itself. This expense charge might be used to cover the annuity’s administrative costs, compensate brokers who sell the annuity and pay for various guarantees, such as a guarantee that the annuity will have some minimum value when you die. It’s debatable how valuable these guarantees are. But the net result is that variable annuities typically have total annual expenses that approach 3% of assets per year, which makes it tough to earn healthy long-run returns.
Some unscrupulous brokers encourage clients to buy tax-deferred annuities within their IRA. That means the clients are putting a tax-deferred account inside a tax-deferred account, which doesn’t make a whole lot of sense—and the advice is usually driven not by the best interest of clients, but by the broker’s desire to collect the hefty commission from selling a variable annuity. That commission is typically greater than the commission that a broker can earn by selling a mutual fund.
Our Humble Opinion: Not all annuities are a terrible investment. For instance, Fidelity Investments and Vanguard Group offer relatively low-cost variable annuities, and these might appeal to high-income earners who have maxed out their retirement accounts and are looking for additional ways to get tax-deferred growth. In particular, the tax deferral from a low-cost variable annuity may be attractive if you’re inclined to buy taxable bonds, real estate investment trusts or actively managed stock funds, all of which tend to be relatively tax-inefficient.
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