Dividend Stocks or Annuities for Retirement?

The debate around annuities and whether they are a good investment choice has been going strong for years and doesn’t seem like it will cease anytime soon. But instead of rehashing the usual arguments, let’s look at it from a different perspective.

If you are currently planning for retirement and are looking for the right financial instrument to achieve the best growth and income results, you are better off using a dividend stock investing approach rather than using annuities.

Key Takeaways

• Dividend stocks provide both appreciation and income, making them better suited for retirement than annuities.
• Annuities have higher taxes and fees, making them more costly than dividend stocks.
• For inheritance, dividends provide a step-up in cost basis, reducing capital gains, and making them beneficial for heirs, while annuities pass on the original cost basis.

Dividend Growth Prospects

When you set up an annuity, the upside on your portfolio becomes very limited. Depending on what type of annuity you choose, you have either no growth on an immediate annuity or minimal growth due to fees on other types of annuities. With a dividend stock portfolio, not only do you get income from the dividend, but you get the capital gains from the stocks’ price growth.

The downside of growth with dividend stocks is that you will take on more volatility because there is no guarantee. As long as you are not selling your stock when the market goes down and are only living off of the dividends, this isn’t a big issue.

On the other hand, if this factor would keep you up at night, guarantees that come with annuities may be worth the growth trade-off for you. Just remember that annuities are an insurance policy, so they’re only as good as the company you buy them from. If the firm goes out of business, you’re out the money.

Important

Taxation on dividends depends on whether they are qualified dividends or ordinary dividends. Qualified dividends are taxed at the lower capital gains tax rate while ordinary dividends are taxed at ordinary income tax rates.

Taxes Stack-Up

When looking at taxes, there are two major differences between the two options. The first is how your earnings are taxed; the second is the cost basis for your heirs if you pass on the asset to them after death.

With the taxes that you pay on your earnings in an annuity, you are taxed at your ordinary income rate. However, with dividend stocks, you pay a lower rate on the qualified dividends—and if you are in the lowest two tax brackets, you don’t pay any taxes.

Additionally, if you sell your stock for a gain, the capital gains tax tops out at 20% for the highest tax bracket. This can make a big difference in the taxes you pay during retirement.

When you pass on assets to your estate, there are different rules for what your heirs’ cost basis becomes. With an annuity, they get the same basis that you had. With stocks, they get what is called a step-up basis—this means that their cost basis is what the price of the stock was on the day you died.

This can make a major difference in how much they eventually get taxed even if you had a 100% gain on the stock. If they sold it for a new basis, they would owe no capital gains tax.

How the Fees Add Up

Fees can destroy the growth potential of a portfolio. They make it harder to reach your goals because you have to not only make the return you need to achieve your goals, but you have to also make back the fees that you pay for the investment.

Having a dividend stock portfolio is one of the cheapest ways to own an asset. You pay a transaction fee to purchase the shares and then don’t have to pay any other fees until you sell the stock.

Most brokers don’t charge for traditional stock purchases and sales anymore. Also, at most brokerages, you can even reinvest the dividends at no additional cost. If you structure your investments so that you eventually live off the dividends and don’t sell the stock, then you only pay one fee.

Annuities, on the other hand, are full of fees. Not only do you have large commissions up front, but you are also subject to surrender charges if you want to get out of the contract, fund expense charges, and many more.

What Is the Biggest Disadvantage of an Annuity?

The biggest disadvantage of an annuity is its high cost. Annuities have several different fees, such as administrative fees, surrender charges, and investment management fees, which all reduce the return on your investment. Additionally, annuities lack flexibility. Once you purchase an annuity, your funds are generally locked in for a long period. You may be able to withdraw, but this can come with penalties.

Can Annuities Be Inherited?

Yes, annuities can be inherited with the income stream or value of the annuity passed to the heir. In most cases, the heir can decide if this should be received as a lump sum or a stream of payments. Some annuities, however, cannot be inherited, such as those with a life-only payout option. This type of annuity will cease at the time of the holder’s death. There are various tax consequences with annuities that beneficiaries should be aware of.

How Do I Avoid Taxes on My Annuity Withdrawal?

If you want to avoid taxes on annuity withdrawals, one of the best options is a Roth annuity, through a Roth 401(k) or Roth IRA. Since these accounts are funded with after-tax dollars, all withdrawals are tax-free. You will have to meet all of the Roth account requirements.

The Bottom Line

Annuities are an expensive way to prepare for retirement given the various costs and fees. Using dividend stocks will see a minimization in fees and taxes, and you still get the growth and income that you’ll need for your non-working years. In addition, they are more beneficial to your heirs from a tax perspective should you pass them on.