Better for Retirement: Dividend Stocks or Annuities?

The debate around annuities and if 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 use annuities. Here's why. (See also: ETFs vs. Mutual Funds: Choosing for Your Retirement.)

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 tradeoff 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.

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. (See also: Is Union Pacific Still a Good Dividend Stock?)

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 step-up basis—this means that their cost basis is what the price of the stock was of the asset 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 the new basis, they would owe no capital gains tax.

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 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. 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.

Annuities are an expensive way to prepare for retirement. 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. (See also: Are Annuities Retirement-Only Investments?)