Variable Annuities Part 2 of 4: Saving for Retirement Easy as I,R,A

Last week we discussed variable annuities, how they work, and how they measure up to the popular 401(k) plan. Now, in Part Two of our series, we’re going to examine IRAs – another alternative to variable annuities that you can still take advantage of (if you’re quick) to limit your tax burden this year.

There are two types of IRAs – Regular and Roth. Each has advantages and disadvantages. Depending on your situation, you may even find that the best strategy might be a hybrid approach to savings and investments. But this article will at least get you pointed in the right direction, and set the stage for a conversation you may want to have with your financial advisor (preferably a fee-only independent one!) 

Regular IRAs

Individual Retirement Accounts, or IRAs, are available through a number of sources. That includes most banks and brokerage firms. IRAs offered by discount brokers provide you with the most investment flexibility and are generally free of any annual fees if your IRA balance is more than $10,000. Furthermore, many discount brokers offer a wide array of no-transfer-fee, no-load mutual funds and low commission levels when investing directly in stocks.

The IRS limits your annual IRA contribution to a maximum of $5,500 per person for 2017 (anyone 50 and older can add $1,000 to that limit). If you’re not participating in a retirement plan at work, the entire amount of this contribution is tax-deductible, meaning you don’t owe taxes on that money in the current tax year.

However, if you are in a work-sponsored retirement plan, then the tax-deductibility of your contribution begins to phase out for 2017 when your modified adjusted gross income (MAGI) exceeds $62,000 per year ($99,000 per year for a couple). If only one spouse is covered by a retirement plan at work, you can deduct up to $5,500 ($6,500 for 2017 if age 50 or older) in an IRA for the uncovered spouse, if MAGI is under $186,000 (phased out completely at $196,000).

As with other retirement vehicles, your contributions will grow tax free until you withdraw them. At that time, you will be required to pay taxes on the entire amount of the withdrawal (excluding any amounts for which you have already paid taxes).

If you make a withdrawal prior to reaching age 59 1/2, you may also owe a 10% penalty to the IRS. But there are exceptions. You can make penalty-free withdrawals from your IRA to pay for your education costs or the education of your children or grandchildren. You may also withdraw up to $10,000 from an IRA to purchase a first home for yourself, your children or your grandchildren without incurring any penalties (though you will still owe taxes on these early withdrawals).

Lastly, the IRS requires that you begin making at least minimum withdrawals from your IRA by the time you reach age 70 1/2.

 Advantages vs. Variable Annuities 

Advantage #1. Regular IRA contributions are before taxes. As you will see in an example shortly, the benefits of this can be substantial. 

Advantage #2. There are no insurance expenses weighing down the performance of your investment with an IRA. 

Disadvantage vs. Variable Annuities

The government limits the amount of pre-tax dollars you can contribute to an IRA to $5,500 per person in 2017, or less depending on your income level. You may need to supplement these savings with other investments in order to have sufficient income during retirement. 

Example

Let’s assume that over a 30-year period of time, Patty Jones saves $5,000 per year toward her retirement under two scenarios: One where she makes pre-tax contributions to a regular IRA, and the other where she takes the same amount, pays taxes on it, and then invests it through a variable annuity.

For the purposes of this example, assume that the net rate of return for each of these two investment vehicles is the same at a conservative 4%, and Ms. Jones is in the 25% marginal tax bracket.

As you can see, your investment will grow much faster when you can fund it with pre-tax dollars through a regular IRA. Now, let’s assume Ms. Jones has reached retirement and decides to convert her investment from 30 years of savings into an immediate annuity with a fixed 15-year payout.

Based on this example, Ms. Jones would receive $2,390 more per year during retirement by investing through a regular IRA than she would by investing through a variable annuity. This result is magnified even further for individuals in higher tax brackets.

Roth IRAs

The Roth IRA was first enacted in 1997, and modified with expanded limits through passage of the Taxpayer Relief Act of 2001. At first glance, the Roth IRA appears to be similar to a regular IRA:

* You’re limited to an annual contribution for 2017 of $5,500 per individual ($6,500 if age 50 or older), which is phased out at upper income levels. Just like with a regular IRA, the annual contribution is limited to taxable earned income.

* The method of investing, and the available investment options you’ll get through a bank or discount broker, are the same.

* You owe no taxes on your annual earnings in either IRA.

But the Roth IRA has several key features which make it much more attractive than a regular IRA, or a variable annuity for that matter.

First and foremost, you fund a Roth IRA with after-tax dollars, and in turn, owe no taxes on your withdrawals. So, while you forfeit any tax advantages in the current year, you more than make up for it by avoiding taxes on your principal and earnings when you withdraw them later.

Second, after five years, the IRS permits you to withdraw any amount that you have contributed to a Roth IRA – tax-free and penalty free – under certain circumstances. For instance, a young couple could contribute to a Roth IRA over several years and then withdraw the entire amount of their contributions to fund the purchase of a house, while leaving their accumulated earnings in the account to continue growing tax free.

Third, the modified adjusted gross income (MAGI) levels used for determining your ability to make a Roth IRA contribution are different from MAGI levels used for Regular IRA contributions.

Individuals making less than $118,000 can contribute up to a full $5,500 for 2017 ($6,500 if age 50 or older), which is phased out completely at $133,000 annual income. The same goes for couples making less than a combined $186,000 (phased out completely at $196,000).

One other consideration: Unlike a regular IRA, the Roth IRA does not require you to make minimum withdrawals when you reach age 70 1/2. Indeed, there are no required withdrawals associated with this investment at all. You can pass it on to your heirs completely income-tax free (though the amount will still be added to your taxable estate for estate tax purposes).

Advantages vs. Variable Annuities

The prospect of tax-free withdrawals and payouts represents a significant advantage for Roth IRAs over variable annuities. Both investments are funded with after-tax dollars so there is no advantage there. But the tax-free payouts in later years can make a big difference in the amount of money you will actually receive.

Disadvantage vs. Variable Annuities

The only drawback to a Roth IRA is that the government limits the amount of your contributions. Therefore, you may need to supplement these savings with other investments in order to have a sufficient income during retirement.

Example

Let’s assume that over a 30-year period of time, Tom Johnson saves $5,000 per year toward his retirement under two scenarios: One where he makes after-tax contributions to a Roth IRA, and the other where he contributes the same amount through a variable annuity. We’ll also assume that the net rate of return for each of the two investment vehicles is 4% and Mr. Johnson is in the 25% marginal tax bracket.

As you can see, the value of your investment remains the same regardless of whether you use a Roth IRA or a variable annuity because they are both funded with after-tax dollars and you pay no taxes on either’s annual earnings. Now, let’s assume Mr. Johnson has reached retirement and decides to receive his investment from 30 years of savings over a fixed 15-year payout period.

Based on this example, Mr. Johnson would receive $2,390 more per year during retirement by investing through a Roth IRA than he would by investing through a variable annuity. This result is magnified even further for individuals in higher tax brackets during retirement.

Bottom line: As with a 401(k), everyone whose annual income level permits them to take full advantage of a pre-tax IRA contribution should consider doing so. You should also consider contributing to a Roth IRA, even though in both cases, you will likely want to supplement your IRA savings with some other form of retirement savings vehicle.

Hopefully this primer on IRAs and how they stack up against variable annuities has given you some things to think about and discuss with your financial adviser. As always, be sure to check an insurer’s safety rating on the Weiss Ratings website – and look for Part Three in our series soon.

Think Safety,

Gavin Magor