by Archie M. Richards, Jr.
July 9, 2007

Annuities are all the rage these days. Most of them aren't as good as people think.

What's an annuity? It's the opposite of life insurance. Life insurance pays after you die. An annuity pays until you die.

Annuities that begin paying benefits right away are called "immediate annuities." You invest a lump sum, and the insurance company pays regular income for the rest of your life - a stream of income you can't outlive.

Your spouse can be part of the deal. After the death of one spouse, payments continue to the other. The annuity can be set up to pay a lesser amount to the survivor, in which case the payments to both parties are higher from the beginning.

In case both spouses die soon after the policy is acquired, the annuity can be set up to continue payments to heirs for a specified number of years. This is called a joint life annuity with a period certain.

But including the heirs reduces the income to you from the beginning. You and your spouse probably won't die shortly after the policy is acquired. Go with the odds. If you fear running out of money, give your heirs the privilege of taking care of their own needs.

The decisions about joint lives and heirs must be made up front. Once begun, the income payments can't be changed.

But you can delay the time when the income payments begin. Such policies are called "deferred annuities." You invest money in a lump sum or over a period of time. The money grows inside the policy and is used later to pay out income.

If the annuity is invested in bonds chosen by the insurance company, the policy is called a "fixed annuity."

If it's invested in mutual funds of stocks and/or bonds selected by you, the policy is called a "variable annuity."

In all cases, the earnings within the annuity are not currently taxable.

The most popular policies these days are variable annuities. Oh yes, the earnings compound tax free. But after the payouts begin (or if you withdraw while you're still alive), the earnings are taxable at high rates as ordinary income. Plus, lump-sum withdrawals before age 59½ are subject to an extra 10-percent penalty tax.

Without an annuity, the profits from stock investments owned outright and held for at least a year are taxed at low rates as long-term capital gains, with no 10-percent penalty. At death, the capital gains are wiped out.

Contrast this with having an annuity: The earnings are taxed upon withdrawal at high rates as ordinary income. In other words, the annuity converts low taxes into high taxes. And at death, the income-tax liability is not wiped out.

There's more bad news: The sales charges deducted from most variable annuities are high and so are the operating costs. If you withdraw the funds within relatively few years, you're likely to pay whopping redemption charges.

Avoid variable annuities. True, they offer certain guarantees of investment results, but you must retain the policy for many years to enjoy those benefits.

If you insist on obtaining a variable annuity policy, acquire it from Ameritas. Its policies have unusually low costs. But you must take the initiative to call the company yourself. No salesman will call.

The best kind of annuity is an immediate fixed annuity (also available from Ameritas.) If this isn't for you, avoid annuities altogether.

If you're not in good health, be sure to tell the insurance company about it. With a shorter life expectancy, the company should increase the income payouts from the beginning.

Equity indexed annuities are also popular. Providing you hold the policy for a minimum number of years, you'll probably receive a maximum stock market gain of 6.5 percent a year, but with a guarantee of at least 3 percent.

Equity indexed annuities generally return no more than a fixed annuity. They're overrated.

If you want stocks, buy them outright, with no annuity. For income you can't outlive, acquire an immediate fixed annuity. That's the best kind.