Which is the best vehicle for retirement savings: a variable annuity, a Roth IRA or a taxable account?

QUESTION: I'm 33 years old and have minimal retirement savings. What's the best way to get started: Variable annuities, a Roth IRA or mutual funds held in a taxable account?

-- Anonymous


ANSWER: A Roth. Next question?

We don't mean to be flip. But given these three options, a Roth IRA -- which offers tax-free withdrawals during retirement -- is simply the hands-down winner. Trust us, by the time you're done reading this answer, you'll agree.

That doesn't mean that the Roth IRA is always the best way to save for retirement. While we are huge fans of the Roth, we'd generally advise those who have a 401(k) or other company-sponsored retirement plan to start there for their retirement savings. Why? You just can't beat a company match. Think about it: If your employer matches, say, 50 cents on each dollar you contribute up to 6% of your salary (the most common match, according to the Profit Sharing/401(k) Council of America), then you just got a 50% return on your initial 6% investment -- and you lowered your tax bill for the year.

But what about those who don't have a company retirement plan? Then a Roth is an excellent choice. (If you own your own small business, you have a few other juicy options) With a Roth IRA, you don't get any sort of tax break on contributions (as one would with a deductible IRA), but qualified withdrawals taken after age 59 1/2 are completely tax-free . In the world of retirement savings, this is pretty exciting stuff. On top of that, original contributions can be withdrawn at any age without penalty. Not that we'd recommend doing that.

Now, the catch with a Roth is that not everyone is eligible: To fully qualify, singles must have modified adjusted gross income (MAGI) below $95,000, while married folks (filing jointly) must have AGIs below $150,000. Also, as is the case with all IRAs, the maximum annual contribution for those under age 50 is $3,000 -- whereas with, say, a 401(k), you can contribute a whole lot more.

Moving on to variable annuities, our advice is simple: skip 'em. That is, unless you have already maxed out all of your other tax-advantaged retirement vehicles, are in a high tax bracket and are determined to sock away even more for your retirement, says fee-only financial adviser Gary Schatsky, president of ObjectiveAdvice.com. The fact is, while variable annuities can make sense for a very small slice of the population, that by no means explains why these mostly lousy investments continue to be as popular as they are.

A better explanation is that the sales pitch is compelling: Variable annuities are tax-deferred investment vehicles that come with an insurance contract, usually designed to protect your heirs from a loss in capital. And unlike IRAs and 401(k)s, there are no contribution limits.

So what's the problem? Where do we start? First off, the fees on these accounts tend to be high. While the average mutual fund's expense ratio is 1.44%, the average total cost for a variable annuity, including the expense ratio of the investments plus the management and insurance fees, is 2.34%, according to investment-research firm Morningstar. (The good news: Low-fee options are available from no-load fund families like Vanguard and TIAA-CREF.) On top of that, the tax treatment is ugly: Non-qualified variable annuities -- meaning those not offered in a company retirement plan -- are purchased with after-tax dollars and withdrawals on earnings are eventually taxed as ordinary income, which can run as high as 35%. Over time, high fees combined with potentially high tax treatment during retirement make variable annuities far less attractive for most investors compared with a Roth or even investing in a taxable account.

Finally, what about a good ol' taxable account? While a Roth will certainly give you more bang for your retirement buck, investing in a taxable account gives you maximum flexibility. If, for example, you think that in a few years you might need this "retirement" money to pay for, say, a car or an engagement ring, or some other non-retirement goal -- you'll be happy you can access this money without triggering a 10% penalty. (How you'll look back on this decision at age 65, is of course, a different matter.) Also, thanks to today's low tax rates, funds held in a taxable account aren't taxed all that much (particularly if you hold tax efficient funds.) Assuming you hold onto your investment for more than a year, capital gains are generally taxed at 15%. Most dividends are taxed at 15%, too.

To bring this all together, we turned to William Reichenstein, investments professor at Baylor University in Waco, Texas. He kindly crunched the numbers for us to see if an annuity could come out ahead of a Roth IRA or a taxable account over the long haul. (To do so, we had to make some big assumptions; these scenarios are just for illustrative purposes.) He calculated how an investment would grow in the three types of accounts, assuming the individual was in the 28% tax bracket both now and in retirement, and that the account grew 8% annually. Based on the tax treatment alone (not factoring in fees at all) it would take 25 years for the annuity account to beat a taxable account -- and it never catches up to the Roth. If, however, you assume the annuity grows at 7% (to factor in the higher fees associated with most variable annuities), while the Roth and the taxable account grow at 8%, the variable annuity never catches up to the taxable account, either. (At least going out 50 years.)

See? We told you you'd think the Roth was the way to go.