Salespeople stress examples like the one above to make their case. And it's clear that
the earlier you buy and the longer you can benefit from tax deferral, the better. But many
young people don't meet the other criteria that make variable annuities a good investment.
Even if you have a long time horizon, variable annuities make sense only if you can answer
yes to all of the following questions:
Are you contributing the maximum to your IRA, 401(k) or other retirement plans?
These plans provide tax deferral without many of the fees. Some offer an employer match
and let you invest pretax money. If you use a Roth IRA, earnings are tax-free in
retirement, not just tax-deferred.
Can you live without the money until you reach age 59½? If not,
you'll be hit with a 10% tax penalty and may have to pay a surrender charge. Make sure you
have enough money available for emergencies and preretirement needs, such as paying for
your children's education, buying a house and supporting aging parents. "When you're
in your thirties and forties, age 59½ is a long way away," says Lambert.
Are you in the 25% tax bracket or higher? If you're in the 15% bracket,
the benefits of tax deferral may never make up for the fees. You'll do best if you defer
taxes while in a high tax bracket and withdraw the money when you drop into a lower
bracket in retirement.
"If you're in the 33% to 35% tax bracket, tax deferral looks good now. But if your
income-tax bracket doesn't bump down, you're going to wish you had capital gains instead
of ordinary income," says Dee Lee, a financial planner in Harvard, Mass.
Do you think you'll need the money before you die? "Variable
annuities are problematic in terms of estate planning," says Lambert. Your heirs will
owe income tax on earnings just as you would. Mutual funds, on the other hand, pass to
heirs income-tax-free.
Have you found a low-fee variable annuity? Annual insurance fees range
from less than $400 to nearly $2,000 on a $100,000 account. There's little reason to
invest in higher-fee annuities. "The only difference I can see is the salesman comes
to your kitchen," says Lee.
The salesperson usually receives about 6% in commission, and the ongoing insurance
costs eat into performance. "What you spend on insurance expenses lowers your
return," says Patrick Reinkemeyer, publisher of Morningstar Variable
Annuities/Life. The publication covers about 50 annuities that offer a version of
Fidelity Equity Income fund, he says.
"Each has different expenses, but they're the same fund," he explains.
"If I buy Fidelity Equity Income in a policy that has 1.5% insurance expenses, I'm
going to have a lower return than with one with 0.75% insurance expenses."
GETTING STARTED
