The third rail of financial investments is the tax-deferred variable annuity. No, you won't die if you touch it, but you may be considered dumb.

These annuities are created by life insurance companies. They allow you to invest after-tax dollars in so-called subaccounts, which are similar to mutual funds and are managed by well-known companies like

Janus

,

Fidelity

,

Vanguard

and

Putnam

. Your money in these subaccounts grows tax-deferred. In other words, you don't pay taxes until you take the money out.

Most of what is written on variable annuities is very negative. The rap on them is that they are expensive and the tax benefits are less than they seem. But I've seen some new research that has led me to reassess my own negative opinion.

But first, let's look at the arguments against variable annuities:

You'll pay an expense ratio of anywhere from 0.6% to 1.4% each year, over and above the annual management fee, for the subaccounts. This is the so-called mortality and expenses, or M&E, cost. Most of this additional cost is to pay for the annuities' unique death benefit, which guarantees a minimum payout at death, even if you've had substantial investment losses in the subaccounts.

Even if you hold your investments in the subaccounts long enough (one year) to qualify for long-term capital-gains treatment, your earnings when you withdraw them are taxed at ordinary income rates, which are higher. That compares unfavorably to mutual fund investments held outside the annuity, which qualify for long-term capital-gains treatment when you sell shares held for more than a year.

Proceeds of a variable annuity do not receive a "step-up" in basis when someone dies. For instance, if proceeds grow from $100,000 to $200,000, the beneficiary would have to pay tax at ordinary rates on the $100,000 of growth. Other types of assets would step up in tax basis to $200,000 at death, so there would be no income tax when sold.

Now I'll take a contrarian view of variable annuities and suggest there could be a place for them. Consider the following:

Let's assume an investor is trying to decide whether to invest in mutual funds directly or use a variable annuity. First, there is no way around the fact that a variable annuity will be more expensive than a direct investment in a mutual fund. It is only a question of how much. In checking the M&E costs of various annuities, I think it is fair to assume the extra expense will average 1% annually.

However, the income-tax issue is not so clear-cut. It was almost by accident that I got my hands on an article written by John Huggard, a

North Carolina State University

professor who is also an estate-planning lawyer in Raleigh, N.C. Huggard's research indicates that current tax laws favor variable annuities.

The assumption that you can hold a fund outside an annuity for more than a year and pay a maximum 20% tax on capital gains is not the whole story. A fund company must distribute gains annually, and the investor then reports them to the

Internal Revenue Service

on Form 1099-DIV. When I spoke with Huggard on the phone, he emphasized that equity funds have an average annual turnover ratio of 82%, so the majority of these distributions turn out to be short-term gains, which are taxed at the higher ordinary income rate.

Huggard maintains that people pay a lot more than they realize in short-term gains on their mutual funds. A few investors, and even some managers, are becoming more conscious of these taxes. Still, most people pick funds based on risk and performance, not tax sensitivity. Huggard argues that mutual funds' short-term gains distributions tip the argument in favor of tax-deferred variable annuities -- even after you take the annuities' extra 1% expense into account.

But that is only part of the story.

Next week I will discuss why I think variable annuities may be a good investment for some people in certain situations. I'll also discuss the step-up in basis in more detail and tell you about a statistical study of variable annuities by

PriceWaterhouseCoopers

.

What is your experience with variable annuities? Please

email me with your comments. Have a great week!

Vern Hayden is a certified financial planner in Westport, Conn. He is a financial consultant and advisory associate of Financial Network Investment Corp. He also is an owner of Hayden Financial Group. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at

Hayden@cwixmail.com.