Variable Annuities: What Are They and Do They Make Sense? Variable annuities are a tax-deferred investment vehicle that comes with a minimal insurance contract so they can qualify for their tax-deferred status.  The insurance is not much more than a thin wrapper to secure that favorable tax treatment.  It only covers your contributions.  It does not cover any of your investment gain.

Variable annuities can be immediate or deferred.  Once you reach 59 1/2 you can begin withdrawing the funds without penalty.  Prior to that time withdrawals are subject to tax and a 10% penalty.  When you withdraw the funds, they are taxed at ordinary income tax rates, which can be as high as 39.6%.  Many financial advisors think you have to hold a variable annuity for 15 to 20 years before it is more tax efficient than a mutual fund, whose capital gains are taxed at the more favorable long term rate of 20%.

Another major disadvantage of the variable annuity are the fees you will need to pay.  The average annual expenses on variable annuities total 2.08% according to Morningstar, which includes fund expenses and insurance expenses.  The average mutual fund charges 1.34%.  Many variable annuities also have loads on their subaccounts, surrender charges for selling early (usually prior to a required holding period, say seven years) and annual contract charges of about $25.  They also don't make sense as an estate planning vehicle.  If you die with money remaining in your annuity, your beneficiary will inherit all the taxes you have deferred.  If the money were in a mutual fund, the basis is stepped-up at death.

Before considering a variable annuity, you should definitely have maxed out on all other retirement investment options, including an employer sponsored 401(k),  403 (b), Simple IRA, SEP-IRA, or Keogh and any other IRA options available to you.  If you have no other good options and want to buy a variable annuity, be certain to find one with low fees.  Mutual fund companies such as Vanguard, Fidelity, T.Rowe Price, and Scudder have some of the lowest fees.  Also be certain that there is a wide range of investment options in your investment subaccount.

For whom do variable annuities make the most sense?

For retirees who fear they may outlive their capital, for high income individuals who don't qualify for a Roth and have maxed out on all other retirement options, and individuals who could be a potential target for a lawsuit.  This also may be an attractive option for providers of personal services who could be liable in a malpractice suit, because in most states assets in life insurance policies and annuities are credit protected.