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Is An Annuity The Right Safe Harbor?



If you worry that you haven't amassed enough funds to retire anytime close to the date you'd like, a variable annuity might help get your plans on track. But these investment products, which allow you to craft a tax-deferred portfolio that can later be converted into an income stream, aren't suitable for everyone.

You pay high fees for the right to accumulate assets tax-deferred in a choice of mutual funds. And only those investors who meet a lengthy set of criteria are likely to overcome the costs and reap real benefits. Here's how to figure out whether an annuity is right for you.

REGULARITY. In general, annuities make the most sense for people who are in a high tax bracket now but expect to be in a lower bracket when they start withdrawing money. Also, annuities are much more efficient if you plan on using the money to supplement your retirement income by receiving your payout in regular installments. If you liquidate the lump sum, you'll owe income tax immediately on all of the earnings. It's far better to remove the money periodically, while the bulk of your cash continues to grow tax-deferred.

But before you even think about an annuity, you should be contributing the maximum amount to any tax-deferred retirement plans you are eligible for, such as a 401(k) or an individual retirement account. Even if you don't qualify for a deductible IRA, you should be stashing the maximum $2,000 a year in aftertax money in an IRA before turning to an annuity. That's because IRAs don't come with the extra layer of fees.

The average variable annuity has underlying expenses of 1.25%. In addition, the average fund expense is 0.77%. You usually pay an annual charge of $28 and, if you want to cash in, surrender charges that start out around 5.5% but decline over six to eight years, says investment tracker Morningstar. Also, most people face a 10% penalty if they withdraw funds before age 591/2. On a positive note, these fees and restrictions may give you the motivation to stay with the program. "The lower level of liquidity is almost a self-discipline mechanism," says Wade Dokken, chief marketing officer for American Skandia Investment Holding.

Eventually, the benefits of the tax deferral should overcome the drag of the high fees--but you'll need to invest aggressively. Even ideal candidates for an annuity should let their investments, predominantly in stock or high-yield funds, grow for at least 10 years before they start receiving income.

Since annuities require you to take more risk and have less access to the money, make sure you already have more liquid funds set aside to cover major expenses as well as emergencies. An annuity really shouldn't be used for the majority of your taxable investable assets, says Farrell Dolan, vice-president for marketing at Fidelity Investments Life Insurance. To help you figure out what percentage of your assets should be in an annuity (if any), Fidelity has designed a free worksheet called AnnuityMatch. Call 800 544-2442 for a copy.

Even if you clear all these hurdles, an annuity might not have much to offer. Despite the appeal of tax deferral, there is a negative side to the treatment of annuities that investors in income tax brackets 31% or higher need to keep in mind: When money is withdrawn, all of the gains are taxed as ordinary income--even long-term capital gains, which otherwise would be taxed at 28%.

SIT TIGHT. Proposals in Congress to cut the capital-gains rate would make annuities even less attractive. "If you're a stock jockey, then I would probably consider waiting it out," says Jennifer Strickland, an editor in Morningstar's Variable Annuity/Life department. But she advises people not to give the proposals too much weight since there probably will be many tax-code changes during the decade or more in which you should plan to hold an annuity.

Don't leave the money there indefinitely, though, because your heirs would be taxed on the earnings. By contrast, outside an annuity, any unrealized capital gains could be passed to them tax-free. "If your goal is to accumulate money to pass on to your kids, annuities are not the way to go," says Gordon Williamson, author of The 100 Best Annuities You Can Buy (Wiley, $19.95).

Ultimately, your satisfaction with a variable annuity will have a lot more to do with performance than tax treatment. "If you put your money into a lousy product, you're going to have a lousy return," says Strickland. To find a good annuity, take into account past returns, fees, and costs relative to the amount of service you'd like. But before you invest your time and effort in choosing one, make sure an annuity belongs in your bag. Amey Stone Annuity Checklist If you answer

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