Help these super savers
My wife and I are in our early 30's and max out our 401(k)s. We've also maxed out Roth IRAs. We still have more to invest each year - but where?
By Walter Updegrave, MONEY Magazine senior editor

NEW YORK (CNNMoney.com) - My wife and I are in our early 30's and max out our 401(k)s. We've also maxed out Roth IRAs in the past, but we believe our income is now too high to do a Roth. We still have about $8,000 a year we'd like to invest for retirement. We're thinking of annuities, but were wondering if you have another suggestion.

- Andy, Boston, Mass.

Many people who are maxing out tax-advantaged retirement savings plans like 401(k)s and IRAs see annuities as the next logical place to invest any extra money they want to squirrel away. And there's an army of insurance agents and other advisers only too willing to encourage this impulse.

But I'm not a fan at all of using annuities as a way to accumulate a nest egg for retirement. And, yes, I do have a suggestion for a better way to invest your extra eight grand a year.

Before I get to that recommendation, though, let me explain my problem with your annuity solution.

The annuity problem

The type of annuity people in your position are most often drawn (or steered) to is what's known as a variable annuity. With this type of annuity, you get to invest in a variety of "subaccounts," which are essentially mutual fund portfolios.

The attraction is that any gains in these portfolios go untaxed until you withdraw them. Which means that annuities operate kind of like a 401(k) or IRA, except you don't get a tax deduction (or the tax-free income in the case of a Roth).

So what's not to like?

Well, to begin with, you may run into some pretty substantial penalties when you withdraw your money, like 7 or 8 percent, or even higher in some cases, and that can last ten years or more. And if you withdraw money before age 59 1/2, the IRS will tack an additional 10 percent penalty tax on top of the income tax you will pay on any gains you've withdrawn. So it can be expensive to get at your money if you need it within several years of buying the annuity.

In addition, there are the fees. There are management fees, which are paid to the manager who chooses and monitors the investments in the annuity's various subaccounts. And then there's the "insurance charge." Although this fee is often represented as a way to pay for various insurance benefits that come with annuities, most of this fee is actually use to pay the generous sales commissions agents and advisers get for selling annuities.

When you add up these two levels of fees, it's not uncommon for many annuity investors to be forking over 2 percent or more of their assets a year for the privilege of investing in a variable annuity.

Finally, when it comes time to withdraw your money from an annuity, any gains you've accumulated are taxed at ordinary income rates, instead of capital gains rates, which means that you may effectively be converting gains that would be taxed no higher than 15 percent into gains that will be taxed as high as 35 percent.

You could argue that the tax deferral of annuities outweighs this tax disadvantage as well as the high investing costs. But I don't believe that's a very good argument. For one thing, it takes many, many years of tax deferral to overcome the drag of those higher fees.

Besides, there's another type of investment that offers what amounts to tax deferral without the disadvantage of big fees - and also offers a tax break when you eventually withdraw your money. Which brings me to that "better way" I referred to earlier.

A better option: a tax-managed mutual fund

Instead of investing that extra $8,000 a year in an annuity, why not invest it in a tax-managed mutual fund?

This breed of funds is designed to minimize taxable distributions to shareholders. Managers of these funds do this through a variety of techniques, but the result is that most - and in some cases, all or nearly all - of the fund's return comes in the form of appreciation of its share price, much the same as a growth stock.

Many index funds also deliver a large percentage of their gains this way because their buy-and-hold approach tends to minimize ongoing taxable distributions. For more on how both types can minimize taxable distributions, click here.

This is a big advantage because it means you pay no tax until you sell your shares. In other words, the capital gains you're enjoying as the fund's share price rises are effectively tax deferred. Even better, as long as you hold your shares longer than a year, those gains are taxed at the long-term capital gains rate.

So as I see it, you have a choice. You can invest your eight grand in a variable annuity, deal with those surrender charges, incur the lofty annual fees and eventually pay tax at ordinary income rates as high as 35 percent on your gains.

Or you can invest in a tax-managed fund (or index fund) with no surrender charges, much lower annual fees and have your gains taxed at the long-term capital gains rate of no more than 15 percent.

I don't know about you, but I'll go with lower fees and lower taxes every time.

One final note: although I don't think it's usually a good idea for people in your situation to turn to variable annuities, I'm not totally "anti-annuity." Indeed, I believe a different type of annuity, an income annuity, can play an important role in providing steady income after someone has retired. (For more on that topic, click here.)

But when it comes to building assets for retirement, I believe there are better ways to go.

_________________________

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.