Annuities: Right choice for you? A primer

Love 'em or hate 'em, annuities have carved out a prominent niche in US financial circles.

Millions of people hold variable annuities, which have a total asset value of over $1 trillion, according to the National Association of Variable Annuities, an industry trade group. Millions also hold billions of dollars in fixed-rate annuities. Yet, despite their growing popularity, annuities are faulted by many critics who perceive them as having high expenses and shoddy payouts.

"Balderdash," grouse annuity proponents, who see them as a convenient tool for retirees and others seeking a steady income stream.

Still, before buying one, you should know the basics. And for that purpose, we offer the following questions and answers:

What is an annuity?

It's a contract in which a provider agrees to pay an investor a certain amount of money over time. Annuities come in two main varieties:

Fixed annuities pay earnings linked to specific interest rates. In recent years that has generally ranged between 5 and 7 percent.

Variable annuities are linked to the stock market. The better the market performs, the more a variable annuity is worth. Accounts are usually managed by a mutual-fund firm.

How do you buy and pay for an annuity?

Annuities are sold by insurance firms, banks, mutual-fund companies, and financial specialists. Payments are made with a lump sum or over time, such as monthly or quarterly.

When you buy an annuity, can you use pre-tax dollars or after-tax dollars?

Both, and that's a source of confusion about annuity products.

An annuity can't be held in a 401(k) plan. But it can go into a tax-deferred 403(b) plan or an individual retirement account.

If you do put money into a pretax dollar account, you will wind up paying two fees: one to the insurance company that created the contract, and another to the company managing the retirement plan. So "paying an insurance charge for a tax-deferred product has no value," says James Hunt, of the Consumer Federation of America (CFA).

Not surprisingly, most annuities are purchased with after-tax dollars. You can generally contribute as much money as you want. But since the amount is not tax deductible, fund your 401(k) plan and IRAs before putting money into an annuity, says Lorayne Fiorillo, author of a first rate analysis of annuities in "Financial Fitness in 45 Days" (Enterprise Press).

Do assets in an annuity grow tax-free?

Yes. But any payments you receive or withdrawals you make are taxed as ordinary income.

Why do some annuities pay out income now, and others pay in the future?

Because annuity payments vary according to the contract. Payouts basically come in two forms: immediate and deferred.

With immediate annuities, investors receive checks almost immediately.

Deferred annuities pay in the future for a set period of time. Payments can be made to cover all or part of a spouse's or child's life after your death. In this sense, deferred annuities are somewhat like a life-insurance product.

What about expenses?

They can be high, compared to mutual-fund products, says Mr. Hunt of the CFA. He says management fees often hover around 2 percent. The average fees for no-load mutual fund are far less.

What if I prematurely pull out of an annuity?

You'll face penalties called "surrender charges." At the end of the first year, they can be as high as 7 percent of the amount withdrawn. The amount drops in subsequent years.

When can I start taking my annuity earnings without tax penalties?

You can't usually withdraw assets before age 59-1/2 without paying stiff penalties.

(c) Copyright 2000. The Christian Science Publishing Society