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Sunday, August 20, 2006 - Page updated at 12:00 AM


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Tax-deferred annuities not wisest investment

Syndicated columnist

Q: I am in the top tax bracket and contribute the max to my 401(k). The phase-out rules and limitations of Roth IRAs close that option.

I am trying to decide whether a low-cost Fidelity annuity is better than investing in a tax-efficient mutual fund.

Is the decision really between tax deferral (while paying ordinary income tax at distribution) in the annuity and no tax deferral in a mutual fund (while paying capital gains taxes on distributions)?

When does it make sense, if ever, to invest in a low-cost annuity?

A: The sales force will tell you there is more to it than that. For the additional cost of the annuity wrapper you get the death-benefit guarantee — if you die, your heirs will receive an amount equal to your original investment or your accumulation, whichever is greater.

At much higher expense, it is also possible to get an annuity with "living benefits" — income guarantees you can receive without dying.

The death-benefit guarantee is an expensive and inefficient way to buy life insurance, and its true cost, according to researcher Moshe Milevsky, is only a fraction of what you are charged.

Living-benefits contracts are proliferating, so it is dangerous to generalize, but the ones I've examined don't compute to a good deal if you exercise the option.

As a consequence, the crux of the comparison really does turn on tax deferral vs. lower tax rates — even when you are thinking about a low-cost variable annuity.

The higher your tax bracket, the greater your incentive to put your money where its earnings will escape high tax rates. That means tax-efficient investments like major index funds or mutual funds specifically managed for tax efficiency. It does not mean tax-deferred annuities.

If you choose a broad index with minimal turnover, your investment will be quite tax efficient. Had you invested $10,000 in the Vanguard 500 index fund in June 1981, for instance, you would have received $36,980 in dividend distributions over 25 years and only $9,528 in capital-gains distributions.

You would have had to pay taxes on those distributions — and rates varied over the period — but you would now have $127,637.

So you would have paid taxes, often at reduced rates, on $46,455 in distributions, while $72,180 of gains would be unrealized (read: tax-deferred).

As long as we've got 15 percent tax rates on dividends and capital gains, investing in tax-deferred annuities doesn't make much sense.

Q: After reading your columns for years, I became convinced that my money belonged in the Vanguard family of funds. This morning I examined a chart of the 30 largest funds and realized that the American Funds family outperformed Vanguard in most every case. Am I missing a better bet?

A: Both have been very good choices. Both firms deliver low-cost management with superior performance.

Investors who don't mind paying commissions for service have been well-served by brokers who suggested the American Funds group. I've mentioned them many times in this column.

The recent performance superiority of many American Funds, however, probably won't be as dramatic in the future.

The American Funds group is a value-oriented shop, and value investing has trounced growth investing since the market crash. If you compare managed value funds from the two firms, they run neck and neck. Here is an example:

Vanguard Wellington, a moderate allocation or balanced fund, returned 11.06 percent annualized over the 15 years ending June 30. American Funds Balanced A shares and American Funds Income A shares provided returns of 10.61 percent and 11.03 percent, respectively, over the same period.

Questions about personal finance and investments may be sent to Scott Burns at The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; by fax at 214-977-8776; or by e-mail at Questions of general interest will be answered in future columns.

Copyright 2006, Universal Press Syndicate



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