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A Check List: Should You Buy an Annuity?

By Jane Bryant Quinn
Sunday, March 3 1996; Page H02


Investors love a tax deferral, which accounts for the huge popularity of variable annuities. But you may shoot yourself in the foot, if you buy them purely for tax aversion. Because of their high costs, annuities may return less after-tax than you'd get from a comparable mutual fund.

On the surface, annuities sound like an easy choice. They're like mutual funds, but because they're a type of insurance product, all your money grows tax-deferred. Your investment choices typically include U.S. stocks, international stocks, bonds, balanced stock-and-bond portfolios and a fixed-income account.

Annuities are for long-term investors; you normally face an exit charge if you sell within five to seven years. There's also a 10 percent tax penalty on money withdrawn before age 59 1/2. All withdrawals are taxed as ordinary income. So investors get no advantage from lower taxes on capital gains.

Here's a checklist, outlining who should do well with variable annuities (VAs). Buy them only if you can answer all of the following questions "yes":

Have you put the maximum amount of money you're allowed into a tax-deferred retirement account? These plans earn you more than a VA will, because you're investing money pretax. Commercial VAs are bought with your earnings after tax.

If your plan permits after-tax contributions, choose those over a VA, too. You'll pay less in annual expense.

Don't put a VA inside your retirement plan, advises Glenn Daily, a New York life insurance consultant. Retirement plans confer tax deferral on any investment you put in them, so you might as well choose mutual funds, which carry lower costs.

Will you invest your variable annuity in either stocks or high-yielding (junk) bonds? If not, the VA probably isn't worth it. You need a shot at high long-term returns to overcome the VA's high costs. If you'd rather invest in high-quality bonds or money market investments, choose mutual funds instead.

Will you start young enough to make the tax deferral pay? You typically have to hold a VA for 16 years or more, if you buy from a stockbroker or insurance agent and put all your money into stocks. That's how long it takes for the VA to do better than straight, stock-owning mutual funds, according to calculations done by the mutual-fund company, T. Rowe Price Associates Inc. in Baltimore. If you buy at 55, for example, you shouldn't cash in until you're comfortably over 70.

T. Rowe Price sells lower-cost annuities (as do Janus in Denver, Scudder in Boston, Vanguard in Valley Forge, Pa., and the discount brokerage firm, Charles Schwab, among others). With fewer expenses, your money builds up faster. Low-cost stock-owning annuities might beat comparable mutual funds after about 10 years.

Is your tax bracket high? If it's not, you might have to hold VAs for 20 years to do better than mutual funds.

Will you turn your annuity into an income for life? Most people don't. They cash out, pay the tax, and stash their money somewhere else. But your money stays tax-sheltered longer if you keep the annuity and draw out a regular income.

Payout annuities give you a fixed income for life. A "10 years certain" clause guarantees 10 years of payments -- either to you or to your heirs. If you die in the 11th year, however, the insurance company gets the remaining money.

Alternatively, you can take regular payments over a fixed number of years. You pay more upfront taxes with this arrangement than with a lifetime annuity. But this system yields larger after-tax checks (with the caveat that the annuity runs dry, if you outlive your payment plan). Your heirs get any money you don't use.

Is this investment for you rather than for your heirs? You get tax breaks on annuities but your beneficiaries don't. When they sell, they'll owe higher taxes on VAs than they would have on comparable mutual funds. For a tax-deferred investment intended solely for heirs, consider a cash-value life insurance policy where all the proceeds pass tax free.

If you already have a variable annuity, don't let an insurance agent talk you into switching to a different one. The agent will have a million reasons but here's the main one: He or she will earn a commission. In most cases, you won't be better off.

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