For Most, Variable Annuities Are a Poor Means to Accumulate Riches

Q: In your Jan. 10 column you stated, “Annuities make little sense for most people.” Could you address this issue in a future column and warn people about the problem of getting stuck in poorly performing annuities? On the advice of a financial consultant I trusted, I purchased two variable annuities two years ago after receiving an inheritance. Since then my investments outside the annuity have outperformed the stock market, while the annuities barely managed 12% annualized.

The problem is now worsened by the fact that my advisor has moved to another brokerage firm. Because my money is in proprietary annuities, they can’t be moved to the new firm.

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A: Oh, don’t get me started about variable annuities. They rank among the most oversold, and often inappropriately sold, investments in the U.S. People get hooked by the idea that their investment earnings will be tax-deferred. What they often miss are the hefty fees they may be charged, the poor performance they may suffer and the difficulty of getting out, thanks to surrender charges.

These charges, by the way, are probably what will keep you in your annuities. You can make a tax-deferred exchange of one annuity for another one any time, regardless of whether your annuities are proprietary.

The new annuity company will be happy to provide you with details. But the surrender fees your current company will charge you to get out of your investments will, most likely, be a significant deterrent. You may have to wait several years for those fees, which usually decline over time, to phase out completely.

There are two basic types of annuities: variable and fixed. Traditional fixed annuities are fairly easy to understand and have a long, reliable history of providing steady income to older, wealthy and risk-averse savers. For example, buying a classic “life annuity” will give you a regular income as long as you live, with the insurer--not you--taking on the risk that you will live a long time.

But variable annuities are another story. If you can figure them out in the first place, you’ll discover that they usually make sense only for someone in the highest tax bracket who is completely maxed out on contributions to other tax-deferred investments (such as a Keogh, IRA, 401(k), 457, etc.). Even then, it’s not clear that a variable annuity has any advantage over a tax-efficient mutual fund.

I have to ask: Why would you want to follow this guy anyway, given how unhappy you are with the results of his advice? Although a 12% return is nothing to sneeze at, it is significantly lower than the stock market average in recent years. Perhaps you should investigate the many companies that offer low-cost annuities, such as the Vanguard Group, Charles Schwab and T. Rowe Price, before trotting after your brokerage friend.

Clarifying Mutual Fund Tax Rules

Q: My husband and I invested in several mutual funds to finance our three children’s college expenses (they are now ages 7 and under). In the past few years, I’ve noticed that the IRS has changed the tax rules such that we now have to pay taxes on the funds’ capital gains during the year, even though we didn’t sell the funds.

Now that investors have to pay capital gains taxes but don’t get credit for any losses such as they would if they owned the stock directly, mutual funds seem less attractive as an investment. We are now looking for a more tax-advantageous method of investing these funds. Any suggestions?

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A: Yes. Don’t let the tax tail wag the investment dog--particularly before you understand what’s really going on.

You’ve always had to pay taxes on capital gains distributions made by your mutual funds.

A capital gains distribution is the money your mutual fund gives you when it sells stocks for a profit. It’s different from dividends, which are payouts of the earnings from the stocks themselves.

Although you may not have received that capital gains distribution in cash--you probably reinvest your distributions and dividends to buy more shares of the fund--you most probably did receive it. (In the rare event the gains were not actually distributed, you got a Form 2439 that told you how much of the undistributed gains you should report on your return, as well as how much of a tax credit you could claim.)

You may be confused because before 1997, the rate you paid on both interest and capital gains was probably the same--28%. When Congress created a lower capital gains tax rate--the top long-term rate is now 20%--you wound up having to fill out a long and mind-numbingly complicated Schedule D, which highlighted the fact that you pay taxes on both distributions and dividends.

You might also be paying more taxes because we’ve had some spectacular gains in the stock market. More money earned means more taxes paid.

You don’t get any “credit,” by the way, for owning an individual stock that loses value until you actually sell that stock. Then you can use some or all of the loss to offset any gains you received by selling stocks that increased in value.

Frankly, most people are too busy with their lives to be actively buying, selling and monitoring individual stocks. That’s why mutual funds are so popular.

If you want to reduce the tax bite, invest in tax-efficient funds or index funds, which mimic a stock market benchmark such as the Standard & Poor’s 500 index. Most mutual fund families and brokerages offer some kind of stock market index fund. Such funds rarely buy or sell stocks, so there isn’t much in the way of capital gains distributions. Right now the dividend yield is close to 1%, so you won’t be paying much in taxes on that, either.

Whatever you do, don’t let your fear and loathing of taxes drive you to make stupid investment decisions that will cost you more in the long run.

Too many people wind up buying overpriced, unsuitable investments solely because they’re tax-deferred. (See the previous question.) Remember, if you have to pay tax, that usually means you’re making money. And that’s a good thing, remember?

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Liz Pulliam is a personal finance writer for The Times and a graduate of the certified financial planner training program at UC Irvine. She will answer questions submitted--or inspired--by readers on a variety of financial issues in this column. She regrets that she cannot respond personally to queries. Questions can be sent to her at liz.pulliam@latimes.com, or mailed to her in care of Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053.