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Ask TheStreet: Annuity Analysis

Tracy Byrnes

Editor's Note: Ask TheStreet is designed to answer questions about the market, terms, strategies and investment methods. Please email us to ask a question, but keep in mind that we cannot offer specific investment or stock-related advice.

My opinion: Stay away.

It's going to take you 10 to 15 years to recoup the high fees you'll have to pay to own an annuity.

Granted, there are some pros to an annuity. You pay a premium -- either in a lump sum or over a period of years -- to open one. After you're paid in full, the annuity company will make regular payments to you over your lifetime or over a shorter specified amount of time, whichever you prefer.

Then it's a lot like a nondeductible IRA. You contribute after-tax dollars, and the earnings grow tax-deferred until you start withdrawing at age 59 1/2. That's the biggest perk. So if you've made the maximum annual contribution to your Roth IRA or traditional IRA, an annuity could be a great way to continue your tax-deferred savings, if you truly understand these products.

Another upside to an annuity is that there are no contribution limits. So you can put in as much as you want each year. In addition, you are not forced to start withdrawing from your annuity at age 70 1/2, as with an IRA. You can leave the money in your annuity as long as you like.

But, of course, there's a catch. And it's big! There are a ton of high fees associated with annuities. (Ah, I can feel the emails coming!) There are big upfront sales charges and back-end surrender charges if you withdraw the money too soon. In addition, there are mortality and expense charges to cover the risk the insurance company takes on to pay you income over a lifetime. And then there are administrative and annual records-maintenance fees.

So all those fees will defeat the point of the tax deferral on your earnings, unless you open them at a younger age.

And another downer: You owe ordinary income tax, which could be as high as 35%, on your annuity withdrawals. If, instead, you had your money in mutual funds, you'd only owe the 15% capital gains tax on the earnings.

One more big bummer: Annuities are in many ways the worse thing to leave to your heirs because there's no "step-up in basis." That means, for tax purposes, your heirs will owe ordinary income tax on the annuity's value from the day you opened the account.

So if you opened an annuity fund for $100 and it's worth $1,000 when you die, they'll owe tax on all the growth, or the $900. With a regular mutual fund, your heirs will get the step-up in basis and won't owe a dime. Instead, they'll have a $1,000 mutual fund investment in their portfolio.

So annuities may not be the right choice for you at this time. "We have mixed feelings about them. We like the tax deferral, but are concerned about the loss of capital gains and dividend tax rates," says Bill Fleming, director of personal financial services at PricewaterhouseCoopers in Hartford, Conn.

Granted, there are some low-fee annuities out there from Vanguard, Schwab and T. Rowe Price .

So, if you're not happy with the returns you're getting from your certificates of deposit, consider some no-load equity and fixed-income mutual funds.

Or check out the life-strategy funds offered by firms like Vanguard and Fidelity. You basically invest in a fund of funds, and the asset allocation between equity and bonds is adjusted as you age, and your risk level changes. So when you're 80, you'll have a much bigger percentage of your investment in fixed income and less in equities. Whereas when you're 55, you'd probably want a bit more equity exposure and a little less fixed income.

So study all your options before you go down the annuity road. There are plenty of other (cheaper) investment vehicles out there that will help you achieve your goals.