Figuring Out If an Annuity Makes Sense for You

Q: I keep reading about annuities and the tax advantages they offer for savings. But I am confused about whether buying one would be a good deal for me. I am 48 years old with one child in grade school. We are in the maximum tax bracket, and our investment portfolio already includes IRAs, 401(k) savings, stocks, real estate and savings bonds. Does an annuity that would help pay for my child’s college education or my retirement make sense? --A.R.

A: Annuities, which are offered by a myriad of insurance companies in an array of shapes, sizes and flavors, make up one of the most devilish investments to decipher. It’s no wonder you’re confused. Basically, annuities are contracts between an investor and an insurance company offering the investor future payments in exchange for an immediate deposit. Annuities are particularly attractive because taxes on the interest generated by the annuity deposit are deferred until the investor withdraws the money. However, the major drawback to annuities is that investors face a 10% federal penalty and a 2 1/2% state penalty if they withdraw funds prior to turning age 59 1/2.

That said, we can turn to your individual case. Our personal finance experts say an annuity does make sense for you providing that you can afford such an illiquid investment for at least the next 11 1/2 years. If, however, you might need to tap these funds at some point before turning age 59 1/2, you should not risk the penalty.

Our experts strongly recommend that if you do decide to purchase an annuity that you get a “variable” account that allows you to move your money from one type of fund to another within the account to take advantage of changes in the prevailing interest rates and other market conditions over the life of the investment. Annuity contracts typically require a minimum investment of $1,500 to $2,000 and allow you to add money to the account over the years as you want. A variable annuity typically allows you to invest in one or more of a variety of stock and bond mutual funds. As we said, any earnings generated by your investments are not taxed until you withdraw the funds--typically after your retirement when you are in a lower tax bracket.

However, all is not sweetness and light with annuities, and you should know about the downside.

Annuities are offered only by insurance companies, and given the sorry shape of that industry these days, you must be careful to select a reputable and strong company to start what is sure to be a long-term relationship.

Further, you should know that variable annuities carry no guarantee that your principal will remain intact. They are also not insured by the federal government or any other industry fund. If you make a poor investment choice and your account loses money, it’s your tough luck.

Our investment advisers--all independent financial planners, by the way--recommend that if you purchase an annuity you do so through an independent financial planner or broker, not an insurance sales representative who will tell you just about the products offered by his company.

To be sure, your financial planner will be paid a finder’s fee or commission by the insurance company for selling you an annuity, but at least you can see a range of offerings from a variety of insurance companies before making your selection.

What to Do With Inheritance Money

Q: I am 37 years old with a wife, two small children and a company that grosses about $350,000 per year. We have IRAs, savings bonds and some stock investments. We have just inherited $50,000 that we want to invest in something “semi-safe” that offers a good rate of return. What do your experts suggest? --T.B.

A: We’re assuming that you are in the highest tax bracket and have paid off all your debts except your mortgage. However, if you do have any debts outstanding besides your mortgage, you should pay those off since the interest they carry is no longer deductible.

Our experts suggest that you put a portion of your inheritance in a conservatively managed mutual fund that offers both growth and income investment opportunities. This will give you liquidity as well as a relatively safe rate of return.

You might also consider putting some of the money to your children under the Uniform Gift to Minors Act (UGMA). Children can earn up to about $500 per year in interest tax free and the tax rate on the next approximately $500 is taxed at just 15%. These accounts could be the beginning of your children’s college savings accounts.

The Ever-Growing Bite of Social Security Taxes

Q: How much will I have to pay in Social Security taxes this year? It seems like it gets bigger and bigger every year. --D.M.

A: The FICA tax rate for employees remains at 7.65% this year; 6.2% of the total is for Social Security while 1.45% goes for Medicare insurance. However, the amounts on which both taxes will be levied increases.

The maximum earnings subject to the 6.2% Social Security tax rises from a $53,400 limit in 1991 to $55,500 this year.

This means that the total possible Social Security contribution increases from $3,310.80 last year to $3,441 this year, a jump of $130.20.

The 1.45% Medicare insurance tax will apply to earnings up to a maximum of $130,200 this year, up from the $125,000 limit last year. This increases the total possible Medicare tax from $1,812.50 to $1,887.90, a rise of $75.40.