What is an annuity and does it
belong in your IRA portfolio?
By Laura Bruce • Bankrate.com

May 1, 2000 -- If you've ever bought a life insurance policy directly from an agent, you probably also got a sales pitch for an annuity. Tax-deferred annuities can be a good way to make sure you have income during retirement -- but critics say that, among other things, they're too expensive and that variable annuities subject you to higher taxes than you'd pay with a mutual fund. We'll take a look at these and other issues and also consider whether annuities belong in your IRA portfolio.

What is an annuity?
An annuity is a contract between you and an insurance company. Whether you buy it from an agent, a brokerage or your brother-in-law -- if he's licensed to sell them -- the contract is only as good as the insurance company that underwrites it, so make sure the company is on solid financial ground.

In essence, you give the insurance company a specific amount of money and the insurance company agrees to make payments to you for a specific amount of time -- even for the rest of your life and the life of your beneficiary. The insurance company is betting you won't outlive the life expectancy predicted by actuarial tables and that it can invest your money so wisely that it will make plenty of profit off your premiums -- far more than it will pay to you.

Who would benefit?
Laurie Lewis of the American Council of Life Insurance in Washington, D.C., says annuities are good for people who don't have a pension plan at work.

"People in their 20s, 30s and 40s who have no steady stream of income beyond Social Security -- we're talking about a stream they can't outlive. This is important, especially as people are living longer. You can buy an annuity that won't run out until you leave this earth and there's no extra charge."

What you need to know
There are a couple of things that most experts agree on when it comes to annuities: Max contributions to your 401(k) or employer-sponsored retirement plan before contributing to an annuity. Even though money in an annuity grows tax-deferred, you're paying a fee to the insurance company. Why pay a fee for a tax-deferred account when your 401(k) does it for free? Also, don't use an annuity for short-term money needs. Plan on letting the money grow for at least 15 years, or steep fees imposed by the insurance company and by the government (if the annuity is in an IRA) will eat up your returns.

There's a lot to consider when buying an annuity. There are many types of annuities and payout plans.

Unlike IRAs, there's no limit to the amount you can contribute to an annuity and there's no rule that says you must begin withdrawing money at age 70-1/2. In addition, earnings grow tax-deferred until you begin taking payments. However, if you make an annuity part of your IRA portfolio it will be subject to the same regulations governing retirement accounts. In an IRA the money contributed might then be tax-deductible in addition to the earnings growing tax-deferred.

Variable annuities are essentially mutual funds with an insurance policy. Some give you the option, for a fee, to limit potential losses by guaranteeing at least a portion of your principal and interest. A drawback is the gains in an annuity are taxed as ordinary income while mutual fund gains are taxed at the usually much lower rate of capital gains. In addition, an annuity leaves your heirs with the tax bill, while a mutual fund that's inherited is granted a stepped-up cost basis so your heirs will pay taxes only on gains that occur during their ownership.

And then there's the expenses
Expenses are a fact of life when it comes to annuities -- contract fees, administrative fees, mortality expenses and surrender charges. Make sure your agent shows exactly what your policy will cost. Fees for variable annuities are listed in the prospectus. The National Association for Variable Annuities says management fees and other expenses typically run from 1.5 percent to 2 percent. You also should know what it would cost if you decide to cancel the contract.

"Annuities are meant to be long-term investments for retirement," says Lewis. "If you withdraw the money early you have to pay for the losses the company has suffered. The company has paid commissions to administer it, underwriting -- they put it out of their pocket and didn't get it back."

As was mentioned earlier, your annuity contract is only as good as the insurance company that issues it. You can check the financial stability of an insurance company through your state's Insurance Division or through a number of companies such as A.M. Best and Standard and Poor's.

-- Posted: May 1, 2000