Variable annuities (VAs) are essentially mutual funds wrapped in an insurance package. When you buy a variable annuity you can direct your investments into a range of stock or bond portfolios, called subaccounts, made available within a particular policy. Tax-weary investors are drawn to variable annuities because contributions grow tax-deferred until retirement, when gains are taxed as income upon withdrawal.
Mutual funds are usually a better deal than VAs, though. Because of the insurance layer, VAs come with relatively high price tags.
Of course, not all VAs are overpriced. The low-cost VA leaders include companies that are familiar to thrifty mutual fund shoppers--including Vanguard and T. Rowe Price. In fact, their VAs come cheaper than many mutual funds, insurance wrapper and all.
VAs may offer current tax deferral, but the IRS does demand a trade-off: VAs are an estate-tax liability. When you die, your heirs will owe income taxes on your account's appreciation. If you passed along fund or stock investments instead, those securities would be stepped up for tax purposes, meaning your heirs' cost basis would be the value of the investments as of your death; they would only owe taxes on subsequent appreciation. We discuss VAs again in Portfolio 401: Variable Annuities.
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