Right investment, wrong time of life

Annuities can be a great way to get steady income for life, but it's a good idea to lay off them until you retire, says Walter Updegrave.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: My wife and I are in our 30's and have $380,000 invested in three annuities and $166,000 invested in 401(k)s, one of which I'm still funding with 6 percent of my paycheck. Do you think it makes sense to have so much invested in annuities at our age? - Craig, Clinton, Michigan

Answer: You and your wife have obviously done a good job of socking away major bucks relatively early in your careers. So assuming the money in annuities wasn't some windfall from a rich relative, you clearly have nailed the single most important aspect of preparing for retirement: disciplined saving.

But I think you could improve on another key factor in building a nest egg - savvy investing. Frankly, I am puzzled as to why you have so much money tied up in annuities. (Although you haven't said so, I'm assuming someone your age is in variable annuities, that is, ones that allow you to invest in mutual fund-like investments called subaccounts.)

I suppose one could make a case for buying them this early on if you had tapped out every other conceivable way of saving for retirement. But I doubt you've done that.

Why? Well, you say you're contributing 6 percent of your salary to your 401(k). I'd be surprised if your 401(k) limited you to such a small contribution rate. My guess is that your employer matches some portion of your contribution up to 6 percent of salary and that you've decided not to put away anything beyond that point.

Even if that's not the case, though, you make no mention of other retirement accounts or investments. Which leads me to believe that you either chose annuities over other options, or that someone convinced you that annuities are the way to go for building a retirement nest egg. In any case, I think there are several moves you can make before you should even consider annuities.

The first is to up your contribution to your 401(k). This is a no-brainer, even if you're not getting an employer match beyond the current 6 percent of salary you're putting away. Why? Well, with a 401(k) both the money you contribute and the gains it generates escape taxation until you withdraw it. With an annuity, the earnings aren't taxed until you withdraw them, but you get no tax break on the contribution. So the 401(k)'s extra tax break clearly makes it a better choice.

If you're getting employer matching funds, well, that just sweetens the deal. The next thing you want to do is fund either a deductible IRA or a Roth IRA for both you and your wife, assuming you're eligible. (You can check that by reading Publication 590: Individual Retirement Arrangements or by using this calculator.) You can put away up to $4,000 each this year, $5,000 in 2008. (People 50 and older can invest an extra $1,000.)

Again, an IRA account not only shelters your investment gains from taxes as long as they remain in your account, as an annuity does, but the IRA also offers a tax advantage the annuity doesn't: an upfront tax deduction in the case of a traditional IRA or tax-free withdrawals in the case of a Roth.

You can debate which someone in your position should choose: a traditional IRA or a Roth. But considering how much money you and your wife already have in tax-deferred accounts - that is, accounts where withdrawals will be taxed at ordinary income rates - I think you're probably better off building up a Roth.

This way, you'll add a pot of retirement assets that isn't subject to the same tax treatment as the rest of your retirement stash. In other words, you'll be practicing what I like to call "tax diversification."

If you've still got money left to save, I'd move on to index funds and tax-managed funds. No, you won't get an upfront tax break as with a 401(k) or traditional IRA or tax-free withdrawals as with a Roth. But since both index funds and tax-managed funds are pretty adept at reducing taxable distributions, you are getting a tax-deferral benefit similar to what annuities offer.

And you get two additional advantages annuities don't offer. One is that tax-managed funds as well as many index funds deliver the bulk of their gains in the form of a rising share price. Which means as long as you don't you don't sell until you've held the shares longer than a year, you'll pay the long-term capital gains tax rate, which maxes out at 15 percent, on most of your gains.

By contrast, all gains in an annuity are taxed at ordinary income rates, which top out at 35 percent, even if the gains themselves are long-term capital gains. Index and tax-managed funds also offer the advantage of lower annual fees. Between the fee for the annuity itself plus the fees on the investment options and, possibly various riders, many variable annuities have total fees that can easily exceed 2 percent a year of the amount you have invested.

You can easily find tax-managed funds with fees that are lower by 50 percent, if not more, and you can find index funds that charge a tenth or less of what most annuities charge. Since there's no limit for what you can invest in index and tax-managed funds, that should pretty much take care of all the money you would want to save for retirement.

That brings us to the question of what you ought to do with the annuities you have. Alas, getting out of annuities is tougher than getting in. Annuities typically have surrender charges that can run from 7 percent to 20 percent. The charge declines over time, however, so you could just wait it out.

In the meantime, you might be able to get some of your cash without an exit fee by exercising the provision in many policies that allow you to withdraw up to 10 percent of your balance without paying a surrender charge.

Surrender charge or no, you'll still owe ordinary income tax on any gains, plus a 10 percent penalty if you're under 59, which, of course, you are. So you'll have to decide (perhaps with the help of an adviser who can run some numbers for you) whether it's worthwhile to take a tax hit to get out (assuming you have gains) and re-invest outside the annuity where the fees are lower and you can possibly get better tax treatment.

If you decide to stay in annuities, consider swapping your current annuities for less expensive ones. A number of firms - Fidelity, Schwab, T. Rowe Price, Vanguard - offer variable annuities with relatively low annual charges.

Another company, Jefferson National, has rather unique variable annuity called Monument Advisor that charges a flat fee of $20 a month for the annuity itself as opposed to a percentage of your account's value. (As with all variable annuities, there's also a charge for the investment options, of course.)

If you're investing a sizeable amount of money - say, $50,000 or more - you can end up paying much less for both the annuity fee and fees overall than the typical variable annuity. If you do switch, first see whether a surrender charge still applies to your current annuities. If so, you may want to hold off until the charge expires or at least until it's not too onerous.

You'll also want to be sure you move into the new annuity via a "1035 tax-free exchange." This will allow you to switch annuities without triggering taxes on your gains. Your new annuity provider can help you with the mechanics of this exchange.

Be aware, though, that switching to a new annuity may also set the clock on a new set of surrender charges, unless you're buying from one of the small handful of annuity providers (like those mentioned immediately above) that offer annuities without surrender fees.

One final note. While I'm not a fan of annuities for building a retirement nest egg, I think a certain type of annuity - an immediate annuity - can often be a good way to get steady income for life once you've retired. (For more on how to do that, click here.)

But whether an immediate annuity makes sense or not is a decision you don't have to make until you're much, much closer to retirement. In the meantime, if I were you, I'd lay off annuities. And I recommend that other readers out there approach them with extreme caution. Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.