Stupid 401(k) Tricks

I'm considering rolling over my 401(k) into a variable annuity. Does this make sense?

The short answer? No. We aren't big fans of variable annuities (to see why, click here), except in very, very specific situations. This is certainly not one of them.

Our general complaint with variable annuities (which are essentially mutual-fund portfolios with an insurance "wrapper" that allows the account to grow tax-deferred) is that the fees tend to be significantly higher than investing in pure mutual funds. (For an explanation of the difference between mutual funds and annuities, click here.) Also, while these accounts grow tax-deferred, the gains on these investments, once withdrawn, are taxed as ordinary income (which can run as high as 35%), rather than the lower capital-gains rates on withdrawals from mutual funds held in taxable accounts. With the maximum capital-gains rate at 15%, that can be a sizeable difference. (Keep in mind, withdrawals from 401(k)s and traditional IRAs are also taxed at ordinary income rates.)

Now, rolling over your 401(k) into a variable annuity creates a different problem. To avoid getting hit with taxes and a penalty fee on what the IRS would view as an early withdrawal, you'd have to roll your account into a "qualified" annuity (basically an annuity product held in a qualified retirement plan, such as a 401(k) or an IRA). "But why would you want to do that," says Dee Lee, a certified financial planner (CFP) in Harvard, Mass. "One of the key factors about an annuity is the fact that it has tax-deferral capabilities, and so does the IRA." In other words, why would you double-defer your retirement savings?

In addition, you'd probably pay more in fees by holding annuities rather than mutual funds or individual stocks or bonds in your IRA. With annuities, annual fees cover both the expenses of the insurance company that offers the annuity as well as the mutual-fund manager who oversees the investments. "The insurance company needs to make money, and it needs to pay the people who are investing the money," says CFP Elaine Bedel, president of Bedel Financial Consulting in Indianapolis.

On top of that, most variable annuities come with an added fee to pay for a so-called death benefit, which guarantees that if your account is in negative territory when you die, it will be made whole. (That's something that might appeal to those looking to leave behind an inheritance.) But despite the recent bear market, this scenario is unlikely. Over the long haul, the stock market has gained ground, not lost it. In fact, the death benefit is triggered in only three of every 1,000 variable-annuity accounts, according to Limra International, an insurance-industry research group.

All told, the average variable annuity comes with fees totaling 2.28% a year, according to Morningstar. And keep in mind that this doesn't factor in the surrender charges you'll pay if you decide to get out of the annuity within the first five years or so. These charges start at a whopping 5.6% (on average) for those looking to sell in the first year, and then drop a percentage point per year until they're eliminated entirely.

"All those layers of costs inside an annuity bother me," says Lee. "I think people can do better on their own." Lee suggests doing a plain-vanilla IRA rollover and investing the money in mutual funds instead. This would cut your annual expenses to an average of 1.44%, according to Morningstar.

It will also give you many more investment choices. You can pick from thousands of mutual funds (click here for our latest fund screens) and invest directly in stocks or bonds. In contrast, with variable annuities, you're stuck with the limited pool of investment options offered — typically just 10 to 40 funds, explains Marilyn Bergen, a CFP with CMC Advisers in Portland, Ore.

If the idea of ultimately receiving annuitized payments during retirement has you leaning towards annuities, your best bet is to set that up when you're about to retire. At that point, you can buy a fixed annuity and begin receiving regular payments. Until then, an IRA will allow for greater flexibility than a variable annuity, at lower costs.

Variable annuities often are a better deal for the person who's pitching them than for the one who's buying them. (If you're working with a financial adviser, you might want to ask about the commission that could be generated by this transaction.) For more on variable annuities, read our story. And for more on IRAs and how to allocate retirement accounts, visit our Retirement section.