Don't Let the Bells and Whistles Distract You

Although variable annuities can pay off in very limited circumstances (discussed below), most investors will do better buying and holding mutual funds outside rather than inside this tax shelter.

Transforming capital gains to ordinary income is harder to justify. The widening gulf between the regular tax rates -- as high as 35% -- that ultimately apply to annuity earnings and the 15% rate for profits from straight mutual funds means it takes longer for the benefits of tax deferral inside the annuity to overcome the loss of capital-gains treatment.

Fees are much higher than for mutual funds. A few companies, including Fidelity and Vanguard, have cut fees, but the average variable annuity still charges 2.09%, according to Morningstar. That's $2,090 each year on a $100,000 account. The average mutual fund claims 1.4%.

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The death benefit isn't worth the money. A large chunk of the fees pays for the death benefit, which typically pays off only if you die when your account has fallen below the minimum guarantee. But chances are slim that you'll lose money over the long haul.

Bill Klipp, president of Charles Schwab Investment Management, points out that "there are far cheaper ways to insure against an event of that sort." Consider, for example, that the average annuity charges 1.11% per year primarily for this death benefit -- $1,110 per year on a $100,000 account. And that doesn't mean you're buying $100,000 in insurance -- most of that money will come from your own account; the insurance only fills in the gap if you had any losses. But a healthy 60-year-old man would pay only about $600 for a $100,000 20-year level-term policy, which would provide the full amount in insurance coverage that is in no way connected with the market.

You don't need a variable annuity to guarantee income for life. One of the most frequently promoted but seldom-used benefits of annuities is annuitization -- which guarantees you set payments for the rest of your life, no matter how long you live. The reason annuitization is relatively unpopular is that it is inflexible: Once the payments begin, you can't change your mind. Much more common is systematic withdrawal of funds, which allows you to decide how much to withdraw at any time. You don't get the lifetime-payments guarantee, but neither do you guarantee that payments end with your death (or the death of a survivor if you choose a joint annuity). With systematic withdrawals, your heirs get what's left in the account when you die.

If lifetime payments are important to you, realize that you don't need a variable annuity to get them. You can invest in stocks or mutual funds until you're ready to start tapping your nest egg, then sell them and use the proceeds to buy an immediate annuity. Yes, you'll have to pay tax on capital gains at that time, leaving you less to invest in the annuity. But because only after-tax money goes into the annuity, less of each payment you receive will be taxed than if you had built up your account inside a tax-deferred annuity.

You need to hold an annuity for at least 15 years. It takes at least a decade and a half for the benefits of tax deferral to make up for the higher taxes and fees. The break-even point depends on your tax bracket, the fees, whether you withdraw the money in a lump sum or gradually over the years, and what you're comparing the annuity with -- particularly, how often you trade taxable mutual funds and how well they perform.

Beware of sales pitches that show a closer break-even point. They're probably based on an assumption that if you buy mutual funds, you'll trade frequently and invest in funds that make significant capital-gains distributions each year. Such assumptions stack the deck in favor of annuities and ignore the advantage of tax-deferred growth, which is yours if you buy and hold funds that make relatively small year-end distributions. That's important because when funds pay out their gains, you have to pay taxes on your share. As gains build up inside a fund, though, you get the same tax-deferral benefit you would inside an annuity and the benefit of a 15% capital-gains rate when you do sell.

"Why pay the cost of a variable annuity just to get tax advantages when you can invest in long-term-growth funds with few or no year-end distributions -- in effect, converting ordinary income to capital gains?" asks Ricky Grunden, a financial planner in Dallas.

Why Variable Annuities Are Just For a Few

When Annuities Can Work