Variable Annuities: The Lowdown

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Insurance salesmen often push variable annuities -- mutual fund-like instruments (which generate hefty commissions) upon investors. But although there are now some annuities out there that are more attractive than those of yesteryear, in general annuities usually aren't the wonder-investments they're cracked up to be. Here are some reasons why:

• Variable annuity fees can be steep. They'll typically scarf up more than 2% of your holdings each year, according to Morningstar. That's negative growth. On a $50,000 account, you'd be forking over some $1,000 annually. (These fees seem to be dropping in recent years, though.)
  
• Earnings grow tax-deferred in a variable annuity, but when the tax is ultimately paid, it's at your normal rate, which can reach nearly 40%. Compare that with the long-term capital gains rate of just 20%. Even if your tax bracket isn't very high, if you choose to withdraw most of your annuity funds at one time, that will likely kick you into a higher bracket.
  
• It often takes at least 15 years before the performance of your variable annuity will match the after-tax returns of investments in a taxable account. You'll be tying up your money for a long time.
  
• The "death benefit" that will pay your beneficiaries at least as much as you put in to the annuity is often a selling point. But it frequently costs more than it's worth. Long-term investments in good stocks are likely to increase, not just maintain, their value.
  
• If you don't draw out the money before you die, your beneficiaries will be taxed on it. Mutual funds and individual stocks should cost your heirs a lot less.
  
• As with instruments such as IRAs, if you withdraw funds before age 59 1/2, you'll be charged a 10% penalty. Better be sure you won't need that money soon.
  
• Variable annuities offer the option of annual payments. But, you could achieve annual income effectively in other ways, such as by selling off small portions of stock holdings each year or investing in other income-producing securities.

Plans such as 401(k)s and IRAs are generally more effective for socking away money for retirement. (Learn more about 401(k)s and IRAs.) Consider maxing those out before looking at variable annuities. Take the time to learn more about annuities before plunking any money into one.

Learn more in our Annuities and Retirement areas -- and from an even weightier source: the SEC. Robert Brokamp tackled them in his article "The 'Criminals' Who Sell Annuities." We've got a discussion board dedicated to annuities, too -- pop in to see what folks are saying.