Annuity Hunting? A Few Caveats

If you're a baby boomer, odds are you're trying to save for retirement. After you set aside pretax money in a corporate 401(k) savings plan--or, for the self-employed, a Keogh--annuities often look like the answer. Annuity earnings compound tax-deferred, just as in a 401(k) plan or ira. But unlike those vehicles, your annuity is almost always funded by aftertax dollars. While many savers choose a fixed-rate investment underwritten by the insurer, variable annuities, which let you invest in one or more in-house mutual funds, are increasingly popular.

FINE PRINT. But unless you're absolutely sure you won't need your savings between now and retirement, annuities can be costly. If you take your money out before you are 5912, the government socks you with a 10% penalty on top of ordinary income taxes on the amount you withdraw. Insurance companies will impose a fee if you bail out early, too. The withdrawal charges generally run 5% to 10% of the amount withdrawn: The sooner you touch your money, the higher the fee. Usually, such charges phase out in up to 10 years.

Variable annuities often have additional charges ranging from 1.5% to 2.25% of your account's value. So you should not only read all the fine print in the prospectus but also make sure your potential return makes the fees, possible tax penalties, and potential surrender charges worthwhile. "It makes no sense to pay the higher expenses of a variable annuity if you chain yourself to money-market returns," says Glenn Daily, an insurance analyst in New York.

Variable annuities work best for those willing to buy high-risk investments, such as aggressive-growth stock funds. Still, some variable-rate annuities sport fees low enough that you can choose a more conservative strategy. And in all cases, whether variable or fixed-rate, only buy an annuity from a top-rated insurance company.

One option for those who balk at high fees, says William G. Brennan, tax partner at Ernst & Young, is a no-load equity index mutual fund. True, you give up the tax advantage, but management fees are razor-thin, and you have access to your money. In fact, Brennan believes even the cheaper fixed-rate annuities have a rival: series ee savings bonds. With these securities, your money compounds tax-deferred, you earn at least 6%--about the same as a conservatively managed annuity--provided you hold the bonds five years or more, and Uncle Sam doesn't charge surrender fees.

Before it's here, it's on the Bloomberg Terminal.