Q. I am in the top tax bracket and contribute the max to my 401k. The phase out rules and limitations of Roth IRAs close that option. I am trying to decide whether a low-cost Fidelity annuity is better than investing in a tax efficient mutual fund.

Is the decision really between tax deferral (while paying ordinary income tax at distribution) in the annuity and no tax deferral in a mutual fund (while paying capital gains taxes on distributions)?

When does it make sense, if ever, to invest in a low-cost annuity?

---M.B., by email from Flower Mound, TX



A. The sales force will tell you that there is more to it than that. For the additional cost of the annuity wrapper you get the death benefit guarantee--- if you die, your heirs will receive an amount equal to the greater of your original investment or your accumulation. At much higher expense, it is also possible to get an annuity with "living benefits"--- income guarantees you can receive without the burden of dying.

The death benefit guarantee is a very expensive and very inefficient way to buy life insurance and its true cost, according to researcher Moshe Malevesky, is only a fraction of what you are charged. Living benefits contracts are proliferating so it is dangerous to generalize, but the ones I've examined don't compute to a good deal if you exercise the option.

As a consequence, the crux of the comparison really does turn on tax deferral vs. lower tax rates. The higher your tax bracket, the greater your incentive to put your money where it's earnings will escape high tax rates. That means tax efficient investments like major index funds or mutual funds specifically managed for tax efficiency.

If you choose a broad index with minimal turnover, your investment will be quite tax efficient. Had you invested $10,000 in the Vanguard 500 index fund in June, 1981, for instance, you would have received $36,980 in dividend distributions over 25 years and only $9,528 in capital gain distributions. You would have had to pay taxes on those distributions--- and rates varied over the period--- but you would now have $127,637.

So you would have paid taxes, often at reduced rates, on $46,455 in distributions while $72,180 of gains would be unrealized (read tax deferred). An investor in the 35 percent tax bracket, would pay taxes of $25,263 on those unrealized gains when the investment was sold while the index fund investor would pay $10,827, a difference of $14,436.

As long as we've got 15 percent tax rates on dividends and capital gains, investing in tax deferred annuities doesn't make much sense. Readers who would like to compare investment vehicles further can use the investment "Horse Race" calculator on my website, www.scottburns.com.