by Archie M. Richards, Jr., CFP^®
May 19, 2003

It's important to acquire stocks. But if you just can't to do so without a guarantee, consider a variable annuity. First, a general explanation.

All annuities have two phases:

• The accumulation phase, during which money is paid into the policy.

• The payout phase, during which money is paid out according to one of several formulas. A formula often chosen is Joint Life Annuity with 20 Years Certain. The insurance company pays income to you and your spouse for life. If you both die within 20 years, the income continues being paid to your beneficiaries for the balance of the 20 years.

On all annuities, you decide when the policy switches from the accumulation phase to the payout phase. Making the switch is called "annuitizing" the policy.

After annuitization, each payout to you consists of earnings plus a return of your principal.

Annuities offer a choice of investments. If you prefer just bonds, the policy is called a "fixed" annuity. If you want mutual funds of stocks and bonds, as I recommend, the policy is called a "variable" annuity. The mutual fund choices offered are called "sub-accounts."

Here are advantages of variable annuities:

• After annuitization, the policy provides a stream of income you cannot outlive.

• For as long as the funds remain within the policy the earnings remain untaxed, even when you switch the money among sub-accounts.

• With some variable annuities, the minimum amounts you may contribute are very small. There's no limit on maximum contributions.

• If the value of the annuity at death is less than the total of premiums paid, the insurance company refunds the difference. Some policies even lock in maximum annual values. For example, say you invest $10,000. The value rises to $12,000. During the next year, it declines to $11,000. When you die, the insurance company adds $1,000 to the policy, returning it to $12,000.

• After you die, the funds available to your beneficiaries avoid probate. Depending on state law, assets within annuities may also be sheltered from the claims of creditors.

Here are disadvantages of variable annuities:

• When earnings are withdrawn from the policy, they're taxed as ordinary income, like your salary, even if they come from long-term capital gains. Annuities convert low-taxed long term capital gains into high-taxed ordinary income.

• The costs of many variable annuities are high: 1) The mutual funds in the sub-accounts have operating costs. 2) Insurance companies add an additional annual charges - up to 1.3 percent. 3) They assess a surrender charge when funds are withdrawn within the first several years. 4) They also assess charges to pay for the guaranteed death benefits.

• Concerning guarantees, the chances of your dying after stock prices have dropped significantly are small. (Most of the time, the stock market goes up.) You're charged for a guarantee you're unlikely to use to any great degree. Insurance companies don't make guarantees for nothing. The better the guarantee, the greater the cost.

• Withdrawals before age 59½ are subject to an additional, non-deductible tax penalty of 10 percent.

• After your death, the tax cost of an annuity held outside of a retirement plan does not "step up" to the date-of-death value. Beneficiaries must pay ordinary income tax on all of the earnings generated within the policy in excess of your original cost.

• Seven states (CA, FL, ME, NE, SD, WV, and WY) assess taxes on the premiums paid.

• For many policies, money must be retained in the policy for ten years or more before the income tax benefits outweigh the extra costs. In case withdrawals might be needed in the meantime, you could be better off owning mutual funds or exchange-traded funds outright.

When annuities are bought within retirement plans, the retirement plan rules prevail. The maximum contributions are limited, for example, and all payouts from an annuity within a Roth IRA are tax free.

Overall, let's say that stocks are completely out of the question for you without a death benefit guarantee. If you're offered a variable annuity whose total costs are relatively low, go for it.

Beats not being in stocks at all.