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Doing the Math on Variable Annuities


If an insurance agent offers you a can't-lose, tax-deferred investment, it ought to be a slam dunk, right? Of course not! It never is. For one thing, agents receive rich commissions for selling these, so you must be wary of high-pressure salesmanship.

If an insurance agent offers you a can’t-lose, tax-deferred investment, it ought to be a slam dunk, right? Then why do variable annuities, many of which promise that you will never get back less than your initial investment, get such bad press? For one thing, there’s a lot of high-pressure salesmanship behind variable annuities (VAs), in part because agents get a rich commission, up to as much as 10% of your investment, on every sale.

A 10% commission can do funny things to a person

And those hefty commissions and no-lose promises don’t come cheap. VAs cost more than a mutual fund, primarily because of high commissions and high expense ratios -- about 2.44% versus 1.32% for the average mutual fund. And most VAs tack on a surrender charge that will last for several years and will hit you in the wallet if you take money out before the surrender period is up. Although a surrender period can be as long as 12 years and the fees can go as high as 10%, most typical is a surrender fee that starts at 7% the first year and goes down by a percentage point each year that you hold the annuity.

In addition, unlike assets you put in a mutual fund in a taxable account, money you take out of a VA is taxed as ordinary income, not at the capital gains rate. Plus you’ll be hit with a 10% penalty if you’re under age 59 ½ when you take the money out. Combined, these factors can wipe out a VA’s tax-deferred advantage.

Wait a're not 59 1/2. Penalty!

Is there a place for a variable annuity in your investment picture? According to many financial consultants, annuities can make some sense if you have a long time horizon so you can avoid surrender fees and if you’ve already maxed out your contributions to other tax-deferred accounts like 401(k) plans or IRAs.

Tip: Ask the sales rep to tell you, in writing, why an annuity is a good investment for you.

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Victor J. Dzau, MD, gives expert advice
Victor J. Dzau, MD, gives expert advice