November 26, 2007 / 10:44 PM / 12 years ago

Re-examining tax-deferred annuities

WASHINGTON (Reuters) - Most tax-deferred annuities have gotten a bad reputation; perhaps deservedly so.

They carry high fees and sales charges; once you’re in one it’s expensive to get out and the tax deferral they deliver may not be so great at a time when capital gains rates are low and there’s a strong possibility income tax rates will be higher in the future, when it is time to take money out of that account.

But tax deferral is still worth something. If you can pile up cash for years without carving out some for Uncle Sam, you’ll have more cash to spend in retirement. IF — and it’s a big IF — you’re not paying too much for the annuity in the first place. And if you fill it with the right investments.

The good news is that there are now more low-cost annuities on the market that fit those requirements. You still have to use them right. Here are some tips.

— Fees really matter. The advantages of tax-deferral can disappear under an avalanche of expenses. Here are the kinds of costs typically associated with variable annuities: (1) A mortality and expense risk charge — the piece that makes it an insurance policy — that is, on average 1.35 percent of the amount of money in the annuity; (2) administrative fees that can run another $20 or $25 per year; (3) underlying fund expenses — the money that the mutual funds within the annuity charge for managing your money; (4) surrender charges — penalties as high as 7 percent for selling your annuity too quickly; and finally (5) sales charges — the commission you pay if you’re buying an annuity from a broker. There might also be added charges if you buy an annuity that has extra riders, like a long-term care insurance policy.

Yikes! It would take an awful lot of tax-deferral to overcome all of that. Consider this example, from Jefferson National, a company that markets a low-cost annuity: Invest $100,000 in an inexpensive annuity with a 0.24 percent mortality charge, earning 6 percent a year, and you would have $311,885 after 20 years. If you used the same money to purchase an annuity with a 1.45 percent mortality and expense charge, you’d have $240,968 at the end of that time. That’s more than $70,000 that you’re leaving on the table, and that doesn’t even count other investment or sales charges.

So ... don’t overspend for the tax deferral. Check out the Jefferson National Annuity (jeffnat.com), which charges a flat fee of $240 a year for its annuity, and also ones offered by Charles Schwab (schwab.com) and Vanguard Investments (vanguard.com), which charges 0.2 percent in mortality fees.

— You still have to invest it right. Even with low fees, it takes about 17 years of savings for the tax deferral to pay off if you’re investing it in large cap stocks. That’s because individual stocks are subject to capital gains taxes that are lower than income taxes; you could probably manage them in a taxable portfolio to keep your tax burden down. But other investments like high yield bonds and real estate trusts are taxed at high-income tax levels anyway. That is what you want to use your tax-deferred annuity for. If all you put in it are long-term bond funds, the tax deferral will pay for itself in a year, says Jefferson’s Larry Greenberg. And when you’re choosing investments for your annuity, remember to keep fees low by choosing index funds or other low-fee funds.

— The best reason to go annuity shopping now is if you already own a tax-deferred annuity from the bad old days, says Cincinnati adviser John Ritter. “It’s a great replacement for so many of the garbage products out there.” Folks who were sold high-fee annuities can’t really cash them out without incurring surrender charges, taxes and — if they are under retirement age — high penalties. But they can do what’s called a 1035 exchange and switch their lousy annuity for a better one. That’s often worth it even if you have to pay surrender charges. You can use comparison calculators at the Schwab and Jefferson Web sites to see if such a trade is worth it for you.

— Tax deferral is better if it comes with a tax deduction up front, so feed your 401(k) and IRA accounts before you buy an annuity.

Linda Stern is a freelance writer. Any opinions in the column are solely those of Ms. Stern. You can e-mail her at lindastern@aol.com.

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