by Archie M. Richards, Jr., CFP^®
August 8, 2005

If you're 65 or older, stay away from variable annuities unless you begin withdrawing income immediately.

A quick primer: An annuity policy is an investment program wrapped in a contract with an insurance company. A variable annuity, the most common kind, holds mutual funds of stocks and bonds selected by the purchaser. (A fixed annuity holds bonds only.)

Annuities have two phases:

• During the accumulation phase, money is invested in the policy, gradually or all at once. No income is withdrawn.

• During the payout phase, the policy pays out income on a regular basis, often for the person's life or the joint lives of a husband and wife. (Guessing how long you'll live is why an insurance company is necessary.) A policy that's paying out regular income is said to have been annuitized.

Here's the good news about variable annuities:

• The investments incur no tax as long as the money remains in the policy. They grow tax free. Compounding is enhanced, because money is earned on funds not previously paid out in taxes.

• The insurance company provides limited guarantees against stock market losses.

Now for the bad news:

• Money paid out is taxable as ordinary income up to 35 percent. This is unlike the treatment of funds held outright (meaning not in annuities or pension arrangements). There, long-term capital gains and most dividends are federally taxed at a maximum of only 15 percent. The 13-percent difference between this and the 28-percent bracket at which many people are taxed is a significant added cost.

  Fewer than 3 percent of policies are annuitized. Most people who buy variable annuities either withdraw the funds or die before annuitizing. Big chunks of money withdrawn all at once can throw the person into a high tax bracket, possibly up to 35 percent.

• The capital gains earned from investments within a variable annuity are not wiped out by death. Whoever receives the money pays ordinary income taxes at high rates on all of the earnings accumulated from the beginning. This is also unlike the treatment of funds held outright. There, death cancels the capital gains, and the investment tax costs become the values as of the owner's death.

• Most variable annuities have high costs. Brokers who sell them receive hefty commissions, usually 7 percent of the money invested. The commission percentage remains at the same high rate no matter how much is invested. This is not the case with mutual funds. There, the commission percentages are reduced as the investment amounts increase.

  To pay the selling cost, variable annuity policies incur extra costs each year. The total annual costs usually amount to 2.5 or 3.0 percent. Plus, money withdrawn within 7 years incurs a redemption charge, usually starting at 7 percent and gradually diminishing over seven or more years.

  Okay, on the one hand, the investments compound tax free, and the insurance company provides limited guarantees against stock market losses.

  On the other hand, the recipients pay high income taxes on funds withdrawn from a variable annuity. Policy values are diminished by high costs all along the line, and capital gains are not wiped out by death.

  There's a balance between the good and the bad. During the first 15 years, if the policy is not annuitized, the bad news usually outweighs the good. Only after 15 years of compounding in a tax-free environment do the annuities begin to pay off.

  In planning your investments, you should assume you'll live to 100. But of course you can't count on this. If you're already retired, you may need heavy money within 15 years for medical and assisted-care costs. If you do, the reasons why you bought the annuity policy in the first place fly out the window.

  If you're facing retirement and you want both limited guarantees against stock market losses and income you can't outlive, fine; buy a variable annuity and annuitize it immediately.

  But forget about variable annuities from which the income is deferred. For retirees, those are bum deals.