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Variable Annuities - Not Right for Everyone

   

Keeping Uncle Sam away from your portfolio is all the rage these days as more and more people set up and add to Individual Retirement Accounts (IRAs) or defined contribution plans set up by employers--known as 401(k) accounts.

Nearly as popular are variable annuities, which also allow investors to defer taxes on investments. While putting the most you can into an IRA or 401(k) plan is clearly a no-brainer, getting into variable annuities definitely requires some thinking.

In the first place, a lot of people don't understand variable annuities, violating the first rule of prudent investing: know what you are getting into. The goal of setting up a variable annuity is to defer paying taxes until you are older, usually after you retire. At that time, you probably will move into a lower tax bracket, thereby paying less tax on your investments. Insurance and mutual fund companies sell variable annuities to individuals who contribute money just as they would to an IRA or 401(k) plan. The companies then take the money and give it to money managers who invest it in stocks, bonds and other assets.

After some time, usually upon retirement, the individual cashes in. The pay out is made over a certain period of years during which taxes are paid. The amount of the payment, as the name implies, is variable and dependent on the performance of the investments. In addition, variable annuities offer heirs a death benefit, just life insurance.

You should only consider variable annuities if you have maxed out on your IRA and 401(K) contributions and still need and want to get out of paying current taxes on dividends and interest income from your stocks, bonds and mutual funds. Oddly enough, many people buy variable annuities even though they have not done this.

Variable annuities often have higher expenses than mutual funds. They usually charge sales fees, annual maintenance fees and surrender charges, which are incurred if the investor wants to cash in early. Indeed it takes six to seven years for an annuity to start becoming cheaper than investing in a regular (read taxable) mutual fund.

But no-load mutual fund companies, such as Vanguard and T. Rowe Price, have been aggressively getting into the market and are expanding their market share by offering lower annual fees.

Among the variable annuities with the best returns are American Skandia Advisors Choice and Lincoln National Multi Fund. Both companies allow individuals to invest in several different funds. American Skandia, for example, allows investors to put money into the Alger Growth Fund, which had an annual 24.7 percent return over the past five years. Lincoln National Multi Fund allows investors to put money into their Special Opportunity fund, which enjoyed a return of 21 percent over the last five years.

Bottom line: if you do want and need a variable annuity, look for those with low expense ratios and good performance over five years. Morningstar and other firms keep such data.

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