Variable annuities offer tax deferral and some stiff costs pTC

Investing

September 23, 1996|By Jeff Brown | Jeff Brown,KNIGHT-RIDDER NEWS SERVICE

UNLESS YOU'VE already got a couple of million stashed, you're probably worried about investing for retirement. Let me guess: Your insurance agent is touting variable annuities.

What could be simpler? You invest in an annuity, and you don't have to pay taxes on the earnings until you begin to make withdrawals after you're 59 1/2 . By postponing taxes, you have more money available to grow, just as you do with a 401(k) or an IRA.

And with an annuity, there's "no limit" on how much you can shelter.

Thus goes the sales pitch. And all of it is true.

But it fails to mention risks that undermine annuities' appeal.

"The tax-deferral feature comes at a price," KPMG Peat Marwick, the accounting and consulting firm, concludes in an analysis of annuities' pros and cons.

"High fees and withdrawal penalties are often so stiff that you'll have to leave the money invested in annuities for years -- and earn consistently high returns -- before you'll match the net return of investing in a comparable taxable investment, such as a mutual fund," it says.

Variable annuities are almost entirely designed as investments, but they have small insurance features that earn them tax-deferred status.

The annuity is run by a professional manager who invests in stocks, bonds or mutual funds. They're "variable" because their returns depend on the manager's skill.

(Fixed annuities, which typically invest in bonds, offer guaranteed -- but lower -- returns.)

A chief drawback to variable annuities is the high fees charged by the insurance company and investment manager. Annuities investing in stocks charge an average annual fee of 2.17 percent, compared with 1.55 percent for comparable mutual funds, Morningstar says.

Because of the higher fees, annuity performance generally lags behind fund performance. The average stock annuity is up 6.46 percent this year compared with 7.91 percent for stock funds, Morningstar says. The average annual gain for the past three years was 11.1 percent for annuities, 11.63 percent for funds.

Modest differences matter. A $10,000 investment held for 20 years would grow to $80,623 if it earned 11 percent a year, $96,463 if it earned 12 percent.

Of course, the fee difference can be offset by the annuity's tax deferral.

If you invested in a taxable mutual fund and didn't touch the money until retirement, you'd still have to pay tax each year on dividends and capital gains distributions -- which wouldn't be taxed in an annuity. Obviously, an annuity's tax deferral is worth more for folks in the 36 percent bracket than those in the 15 percent bracket.

On the other hand, the long-term profits you'd make in a taxable fund would be taxed as capital gains, at a maximum of 28 percent. When you start making withdrawals from your annuity, the earnings are taxed as income, which can be a rate as high as 39.6 percent.

Moreover, any money you take out of an annuity before you turn 59 1/2 is subject to a 10 percent IRS penalty. And, the insurance company may charge a "surrender fee" if you pull all or part of the money out early. Surrender fees average about 5.5 percent of the amount withdrawn, according to Morningstar, but terms vary widely.

Annuities aren't necessarily bad investments. But to make one pay off, you need to satisfy all the following criteria: You're sure your money will stay in the annuity for at least 10 or 15 years; your tax bracket is 36 percent or higher; you've already put the maximum allowed into other tax-deferred investments such as an IRA and 401(k).

And be sure to read all the fine print. Salesmen love to stress the tax benefits -- and downplay the fees.

Bill Atkinson's column will return in two weeks.

Pub Date: 9/23/96

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