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.