Published: Friday, 23 Oct 2009 | 12:32 PM ET

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Annuities can be a cash cow for insurance companies and the people who sell them -- making it vital for you to understand them and trust your source of information.

There may be less expensive ways to achieve the same outcome with another investing strategy. As with any big investment, discuss what is right for you with a trusted adviser who knows your entire financial picture.

Beyond sheer complexity, annuities have certain characteristics.

Mortality credits

Annuities are insurance against outliving your money, and the reason they make sense for some people is the mortality credits.

Mortality credits should be viewed as a threshold investment return that is required to beat the income from the annuity, wrote Moshe Milevsky, associate professor of finance at the Schulich School of Business at York University.

It's complex stuff, but here's a simple explanation: Imagine that 10 people at age 75 all invest $1,000 at 5 percent interest.

Collectively they put in $10,000 and receive $500 interest. Everyone gets back their $1,000 plus $50.

"Now say only the people at the end of the period who are alive will share in the proceeds. At the end we know there will be $10,500 but we assume only nine people will be alive," says Larry Swedroe, principal and director of research at Buckingham Asset Management in St. Louis.

"Insurance companies have big pools of people and they know actuarially that there will be nine people left. If there were nine people left and no insurance company involved, each person will collect $1,167 so the return jumps to almost 17 percent," he says.

The difference between 5 percent and 17 percent -- 12 percent -- is the mortality credit.

The older you get, the bigger the mortality credits get. By buying an annuity that pays income for life, you're betting that you will live longer than the average person who buys an annuity. Obviously, the insurance company believes you will do otherwise.

"If you're young, the odds of you dying in the next 10 years are close to zero so the mortality credits are close to zero," says Swedroe.

Bottom line: For many people, it won't really pay to buy an annuity until their mid-70s, when the mortality credits get to be large enough to make it worthwhile.

Taxes
Though deferred annuities allow you to put off paying taxes, they don't eliminate taxes altogether.

Through the end of 2010, the capital gains tax rate is zero percent for the two lowest tax brackets and 15 percent for everyone else. Beginning in 2011, capital gains rates go up to 10 percent and 20 percent, respectively, unless Congress intervenes. That's still lower than most ordinary income tax rates, which go as high as 35 percent.

That means long-term gains on most investments that you sell in a taxable account are taxed at lower rates.

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But withdrawals from annuities get a different tax treatment than regular investments.

In a deferred annuity, "If I'm in the first period, the accumulation period, and I pull money out, it's LIFO -- last in, first out. So what I'm withdrawing first is interest. So it's 100 percent taxable income: no capital gains rate, no preferred dividend rate," says Mark LaSpisa, CFP with Vermillion Financial Advisors in South Barrington, Ill.

After annuitization, the income investors receive is taxed slightly differently. Part of the payment is considered return of principal, so it is untaxed.

As for the earnings: "Part will be considered income and part will be considered capital gains. That is where you come up with this blended (tax) rate on the payment that you get," says LaSpisa.

Your heirs are also taxed differently if they inherit an annuity as opposed to another type of investment, such as a stock or mutual fund.
If your beneficiaries take the money from an annuity in a lump sum, then the entire account becomes taxable the year they receive it, and it's taxed as ordinary income.

Next: Fees, restrictions, and risks...

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