Significance

• Taxes on the gains made from buying and selling stocks are called capital gains. Capital gains on investments held for a year or longer qualify for a lower tax rate. In 2009, the maximum capital gains tax rate was 15 percent. The growth in a variable annuity is taxed at the owner's regular income tax rate when withdrawals are made from the annuity. In 2009 the maximum tax rate on regular income was 35 percent.
  
  

Features

• Variable annuities allow investors to allocate the money deposited in the contract into separate accounts holding stocks or bonds like mutual funds. A variable annuity allows taxes on gains to be deferred until withdrawals are made. In contrast, a mutual fund is required to distribute any net capital gains in the calender year when they were realized. Mutual fund investors must pay taxes on the capital gains for any year they are paid.
  
  

Expenses

• Variable annuities have significantly higher internal expenses than mutual funds. Annuities are insurance products, and the insurance company charges fees to provide a small level of life insurance protection. In addition, each separate account has expenses similar to mutual funds. The result is the average stock fund will have expense ratios of around 1.0 percent. According to an article in USA Today, the average variable annuity has contract fees of 1.3 percent plus a contract fee of $27 on top of the expenses of the separate accounts.
  
  

Considerations

• When comparing variable annuities to mutual funds, an investor must weigh the taxes and expenses. Mutual funds have lower expenses, and the taxes on long-term capital gains are lower than regular income tax rates. Mutual funds must pay capital gains every year, so taxes will be due every year. Variable annuities allow the deferral of taxes until retirement but have higher expenses, and the gains will be taxed at regular income levels.
  
  

Expert Insight

• Morningstar notes that it takes 10 to 15 years of growth for the tax-deferral feature of variable annuities to overcome the higher expenses when compared to mutual funds. Investors also must take into account their current tax rates and the income tax rates they may have to pay at retirement. It is often assumed that a retiree will be paying a lower tax rate than when he was employed. This is dependent on the level of retirement income compared to the earnings when working.