Paul, a frequent poster on the Bogleheads Forum, recently asked my opinion about Vanguard variable annuities (VA) for doctors and other highly paid professionals. As regular readers know, I generally recommend against mixing investing and insurance, as you usually end up with the worst of both. But the main argument against VAs is not that they are without advantages, but that the advantages cost way too much. By buying variable annuities through Vanguard, you can get them much cheaper. Perhaps then the advantages would be worthwhile enough to consider them in comparison to a mutual fund (MF) in a taxable account. Well, let's analyze this a bit.
There are two main advantages to consider with a VA. First, they grow in a tax-deferred manner. You pay no taxes on them at all until you pull the money out of the annuity. Second, in many states they are an asset that receives protection from creditors, unlike your taxable brokerage account in which you might hold a more traditional MF.
There are really three factors to consider in comparing low-cost mutual funds and a low-cost VA.
# 1 Cost of the VA versus the MF
While most VAs will cost you 2-3%, or even more, Vanguard offers annuities for a total expense of around 0.5%. That's still quite a bit more than most of its index funds with an ER of around 0.1% for the admiral versions, but at least they're able to get close.
# 2 Tax-inefficiency of the Asset Class Held in the VA
The more tax-inefficient an asset class, such as nominal bonds, TIPS, or REITS, the more valuable the tax deferral available in the VA. Of course, when you pull the money out of a VA, all the gains are taxed as ordinary income, not at the more favorable capital gains rate. You also lose advantages of a taxable account such as a step-up in basis at death and the ability to tax-loss harvest.
# 3 Asset Protection Benefits of a VA
Every state is different, but in some states, (not mine), a VA is a retirement account and protected from creditors like an IRA or 401K. You never want the tax “tail” or the asset protection “tail” to wag the investment “dog”, but there is a real value to asset protection for most lawsuit-weary physicians.
Making the Comparison
Let's first consider a tax-inefficient asset class, such as REITs. Let's make a few assumptions. Let's assume an 8% pre-expense and pre-tax return, which is composed 100% of fully taxable dividends. The Vanguard mutual fund (admiral shares) has an expense ratio (ER) of 0.1%. The Vanguard REIT VA has an expense ratio of 0.58%. Let's assume this physician investor is in the 28% federal bracket and the 5% state bracket and invests $10,000 per year and liquidates the investment without penalty at the end of the period specified.
After 1 year
Mutual Fund $10,529
Variable Annuity $10,497
After 10 years
Mutual Fund $134,239
Variable Annuity $134,434
After 30 years
Mutual Fund $794,698
Variable Annuity $832,448
This overstates the case for a REIT fund by a small amount, as some of those gains would be capital gains and taxed at a slightly lower rate in the mutual fund. It also ignores the benefits of more liquidity, tax-loss harvesting, and the step-up in basis at death. But as you can see, the benefit of the tax-deferral starts making up for the higher expenses and the higher tax rate at withdrawal of the VA after about 10 years. At 30 years, there is a clear advantage for this highly-tax-INefficient asset class, especially if you are benefiting from additional asset protection. (This all assumes, of course, that the decision is between a VA and a taxable account, NOT a 401K, IRA or other tax-protected account.)
What About A Tax Efficient Asset Class, like Stocks?
Next, let's consider a very tax-efficient asset class held in a VA, such as the Vanguard Total Stock Market Fund. Again, we'll make a few assumptions: An 8% pre-expense and pre-tax return, of which 2% comes from dividends taxed at 15% and 6% comes in the form of long-term capital gains, the same 33% marginal tax rate and the same $10,000 per year investment.
After 1 year
Mutual Fund $10,649
Variable Annuity $10,504
After 10 years
Mutual Fund $145,299
Variable Annuity $135,010
After 30 years
Mutual Fund $1,015,453
Variable Annuity $846,585
As you may notice, with a tax-efficient asset class, the VA never catches the MF. In fact, after 30 years, you've basically paid $169K for nothing but some asset protection. That seems pretty expensive to me.
Conclusion
Most investors, including high tax bracket investors like physicians, probably shouldn't invest in even the low-cost Vanguard variable annuities over a taxable account. However, an exception can be made if you value the asset protection benefits highly, don't have any room in your tax-protected accounts for a highly tax-inefficient asset class that you feel you really want to hold in your portfolio, don't mind the loss of liquidity, don't mind the loss of tax-loss harvesting ability, don't mind the loss of the step-up in basis at death, and you have a long investment horizon. Since most doctors aren't even maxing out their available retirement accounts, there's little reason for them to consider even inexpensive VAs.
In part 2, u mean tax inefficient.
I think that’s a typo
Otherwise great article.
You’re right of course…changed.
Helpful article, but I have a rather different problem that even boggleheads had a hard time pegging down.
My wonderful grandparents purchased a retirement VA for me when I was a child rather than start a college fund; I have no idea who talked them into that. It’s now worth about equal to my 6.8% medical student loans.
From everything I read I’d have to pay current income tax rates (currently a resident, so no big deal to spread the withdrawals out over a few years and keep total income limits low to qualify for Roth IRA/etc) plus an additional 10% penalty on about 90% of the total value (this fund did do rather well over 20 years; hence my slight apprehension about just liquidating it). I would only end up being able to pay off about half of the student loans after taxes/penalties.
Leave it in the VA and move it to Vangaurd, or cash it out and pay down the loans? Can anyone direct me to someone who might have good insight into this? Trying to do all the various math in excel makes my head spin.
If you’re in a high-expense VA, I’d definitely roll that over (1031 exchange) tax-free to a low expense VA at Vanguard. Your real decision is whether to cash it out and pay off your student loans with it. The first step is to calculate your basis on it. Remember, someone paid money into this VA. How much is that compared to its current value? If $200K has been paid into it, and it’s worth $220K now, then you only owe tax and penalty on $20K, which is no big deal, and the guaranteed 6.8% return of paying off your loans looks pretty appealing.
I think you’re saying that 90% of this investment is taxable, which is really pretty incredible for the last 20 years. You’re saying the investment has had a 900% return (12.25% a year after expenses)? Seems rather unbelievable, but I suppose it isn’t impossible. But if that’s the case, you’re probably looking at paying a lot of tax and penalty. Let’s assume again that it’s worth $200K, but that only $20K has been paid into it. Now you would owe tax and penalty on $180K. Assuming you can pull that money out over 3 years at perhaps a 25% marginal tax rate + a 10% penalty, you’re looking at paying 0.35*180K=$63,000 in taxes. I think I’d rather hold on to that VA until retirement in that case. You don’t have to put any more money into it, it grows tax-free (until you pull it out) and you can get reasonably low expenses at Vanguard. Then again, if you can continue to get 12.25% returns…..I might leave it exactly where it is and not tell anyone else about that investment. 🙂 At that rate in 30 years your $200K will be worth $6.4 Million.
Do you have Roth 401k available at your hospital? Would potentially consider cashing out and maxing out all Roth space (Roth 401k and IRA) before paying off the loans while in lower tax bracket. What would be best could depend on how much tax deferral you will have as an attending and assumptions on tax rates in retirement.
Indeed a very helpful article. That VA have the advantages; first they grow in a tax-deferred manner that you pay no taxes on them at all until you pull the money out of the annuity and in many states they are an asset that receives protection from creditors.
I would put a portion in whole life and over fund it. The cash on cash return is not to attractive about 3.6%, assuming you are a doctor and in a high tax bracket the pre tax equivelent would be about 6%. If you need the insurance the net of term insurance return would be about 7.. in the MF world need a pre expense return of 8%.
I disagree with your estimates of whole life returns as explained elsewhere on the blog. First, those whole life returns (and I think 3.6% is a good estimate) are over the very long term, 2-3 decades plus. You’re then comparing it to a much more liquid investment and also assuming said investment would be taxed at your regular tax rate, not a lower capital gains rate or perhaps even tax free. You’re nuts to think 3.6% in a whole life policy is the equivalent of a return of 8% in a good tax-efficient stock index fund. I do agree if someone decides to do whole life that they should overfund it though. They should also pay on an annual basis.
Does an annuity really have protection against creditors — if I get sued? They can’t touch any of the money therein?
Varies by state.
Can you do us a favor. Since capitol gains rates have increased to 20% and that there is also a medicare surchage on earnings of 200k single, 250k married at 0.9%, can you factor this in to determine whether the variable annuity or s and p 500 is the better choice. I’m just not good at math problems.
Thank you whitecoatinvestor.
The better choice for what? You realize you’re comparing apples and oranges, right? A VA is a type of account, the S&P 500 is a stock index. Do you mean investing in the Vanguard S&P 500 index fund inside a VA vs investing in the Vanguard S&P 500 index fund in a taxable account? Over what time period? With what marginal tax rate? What expected returns would you like to use for the investment? It isn’t a math problem so much as it is deciding what assumptions to use. Garbage in/garbage out and all that.
As a general rule, if you’re going to use a very tax efficient investment like a stock index fund, the VA is a poor choice.
Let me ask if these numbers are correct. Can we assume 8% s and p 500 with 2% dividend and 6% over a 30 year period starting at the age of 30, so at age of 60 no 10% penalty in the variable annuity. Lets assume 33% federal, 6.37% state, 3.8% medicare surcharge. Lets say the expense ratio of the s and p 500 fund is 0.5% and the yearly fee to keep the variable annuity is $2000 assuming I start with 100,000.
Now if I were to put the money instead into vanguard s and p 500, the fee is 0.05%, long term capitol gains 20%, medicare surcharge 3.8%, state tax 6.37%. I pay tax once on the index when I sell it which will be long term capitol gains and capitol gains yearly on the dividend.
I put in $100,000 once at age 30, then at age 60, which one would will have a greater value? I’m trying to prove to someone with mathematics that the variable annuity mathematics wise with these numbers is not a good deal.
Using your assumptions:
$100,000 invested at an 8% pre-fee return, 0.5% ER plus 2% per year in VA fees (you can get these much lower by the way) on the VA, 0.05% ER in the taxable account, marginal rate of 39.37%, capital gains/dividend rate of 23.8%, 30 years then pull it all out.
The taxes on the dividends and the ER cause the return on the taxable account to be 7.47% per year. After paying capital gains taxes at 23.8%, you’ll have $685K.
The fees and the ER on the VA cause the return on the VA to be 5.5% pear year. After paying your full marginal rate on the gains at 39.37%, you’ll have $342K.
I agree that under these assumptions the VA probably isn’t a very good idea. However, if you used Vanguard’s Total Stock Market VA, your expenses would be only 0.48%. If that were the case, then after 30 years you’d have $573K, which is a lot better, but still not as good as a taxable account.
You need a less tax efficient investment than a very tax-efficient stock index fund to make a case for even a cheap VA. The longer you hold it, the more likely that the deferred taxes as it grows will make up for the higher tax rate upon withdrawal, even without the 10% penalty.
In state of New York, most physicians pay the alternative minimum tax at 28% and state tax in the 7-11% range. With the increase in long term capital gains tax and dividend tax to 20% for these physicians, the 8% tax differential is very little considering the vanguard annuity could be used to hold dividend paying stock, bonds and real estate and also have asset protection in NY.
Considering that physician income is decreasing, it could be valuable to have this asset in retirement provided that a 401k is maxed out. The only way that this would change is if the AMT/dividend rate differential increases or tax rates in general go up.
I have a VA that was gifted to me by a relative 25+ years ago. I am in my early 60s and want to start taking income from it. Do you think I should transfer it to Vanguard’s low cost VA and purchase the optional income rider with the VA or just buy a SPIA instead. I was thinking thst maybe using a portion of the existing VA to buy a SPIA and then put the rest in the Vanguard VA. I want the VA to continue growing but I would like to take income from it too. If I don’t purchase the income rider then what would be a safe withdrawal rate so that the VA continues to grow and I don’t zero it out over time? Thanks
If your main goal for it is income, then I think a SPIA, especially an inflation indexed one, is the best choice. There are other choices obviously, but I don’t think they’re as good. If you want to hold out a few years before annuitizing it (some say 70 is better than 60 due to mortality credits) and keep your options open, you can put it in a Vanguard or perhaps even less expensive Jefferson National VA and just take withdrawals from it for income for a few years. But if the market tanks in the next couple of years, you may regret not annuitizing it today.
How would the math change if you are in the 39% federal + 6% state marginal brackets? Seems like tax deferral would definately win out at higher tax rates.
Also, I have found this VA with fees that are lower than Vanguard’s:
https://www.jeffnat.com/monument-advisor/
Fees are a flat rate of $240 per year regardless of account balance plus ability to invest in low cost vanguard and DFA funds (For example, Vanguard REIT index for at an ER of 0.27, Vanguard total stock market ER 0.18).
https://www.jeffnat.com/advisor/aboutfunds/annuityfundperformance.cfm
I’m considering investing all my income in the 39% +6% bracket in this largely for tax deferral purposes (approx 100k/year).
If you’re going to do a VA, Vanguard’s is excellent for small amounts and Jefferson National’s, with its flat rates, is excellent for large amounts.
The longer you hold the VA, and the higher your tax bracket and the more tax-inefficient the asset class held in the VA, the more likely it is the deferred tax in the VA can make up for the fact that it turns what would be qualified dividends and LTCGs into ordinary income.
I think you should call and understand the TOTAL fees for whatever portfolio you are recommending. It’s hard to get at the information, but burried in the documents when you do get them is that the Jefferson National plans are NOT less expensive than the Vanguard option. They have other fees, including “low cost investment options” extra fees. So if you try to go the low cost index route, they add fees that make it more expensive.
On page 10 of this: https://www.jeffnat.com/secure/jef/products/productsummary.cfm?docid=33FFC963BEF11782BB50F027AD9D96DFA06B39B87E65D8A3723349464D6A39A0&product=JMON3
You will see that in addition to the $240/yr fee they charge, they say that the minimum… minimum expense ratio combined for their cheapest investment option is .54%, and the maximum net fee is over 3%.
So if you add in the $240, even on a, say $1 mil initial investment, then take the minimum expense, then you are more expensive than Vanguard.
Perhaps the fees have changed in the years since you did an analysis, or perhaps I’m reading it wrong myself, but I looked extremely closely at Vanguard and Jefferson National, and the clear winner on costs, no matter the account size, was Vanguard.
Plus, honestly, who do you think is most likely to lower their expenses/costs over the next 20 plus years you may hold the Annuity?
By the way, I’m still annoyed I have to pay .58% for the Vanguard High Yield bond account through the Variable annuity, but can get the same Admiral class mutual fund for .13% in a taxable account. I followed your advice and did the math on it, and at current yields it takes 18 years for the advantages of tax deferral to make the Annuity better than the Taxable investment (since both are taxed at regular income, it’s just a race between higher expense ratio versus power of compounding). But, interestingly enough, if interest rates increased to say historical high yield norms, it’s less than a decade before the Annuity makes more sense.
I agree with your conclusions that investing in equities would probably never make sense due to the tax rate differences, but for high-yield bonds, Annuities might. But it’s not a slam dunk even then.
You learn something new every day. Doubt that’s a change. I probably just never dove into it as deeply as you just did. Thanks for pointing that out. Doesn’t look like there’s much reason to go to Jefferson National is there. Guess I’ll just send people to Vanguard from now on. Bummer.
I decided to go with Jefferson National. I am using an RIA to manage the account since he uses a proprietary tactical managed program that has worked so far. I have avoided the market downturn since he is in a cash position. Normally I would use indexed funds but since my time horizon is shorter, I felt it was worth the extra expense to pay a management fee vs exposing my portfolio to volatility risk.
I hope that works out for you. You realize “proprietary tactical managed” can mean just about anything, right?