Before you buy an annuity, consider the following:

The money contributed to a nonqualified annuity may be in post-tax dollars. When you contribute after-tax savings to an annuity, you can put as much money in as you like. Before you put after-tax savings into an annuity, it may be advisable for you to put the maximum pre-tax amount into a retirement plan such as your IRA, SEP, 401(k) or 403(b). Also note that annuities may fund an IRA, SEP, 401(k) or 403(b). When an annuity is used to fund these vehicles there are contribution limits that apply, and federal tax laws generally require that you begin taking minimum distributions by April 1 of the calendar year following the year in which you reach age 70 1⁄2. Failure to do so will result in a tax penalty of 50 percent of the amount of the shortfall. Additionally, once money is in your 401(k) or 403(b) plan, you generally cannot make withdrawals before age 59 1⁄2 except for special circumstances, such as severance from employment, death or disability. If you meet an exception, withdrawals are subject to ordinary income taxes and may be subject to a 10 percent federal tax penalty for pre-59 1⁄2 withdrawals.

When you buy an annuity, expenses can vary. Make sure that the annuity contracts you consider have competitive fees. Independent rating services such as Morningstar and Lipper Analytical Services publish reports that compare variable annuity fees. While cheaper doesn’t necessarily mean better, if a contract is too expensive it could offset gains from the tax-deferred status.

All earnings from annuities are taxed as ordinary income. If your ordinary income tax rate at retirement is higher than the current long-term capital gains rate for certain investments, you would actually pay higher taxes. You do, however, gain a tax deferral on earnings. With some other investments, you could be subject to ordinary income as well as capital gains taxes annually, even if you have not cashed in the investment, which can reduce the value of your earnings.

If you’ve decided that an annuity makes sense for you, here are several key questions to ask yourself before signing up: 

• Have you done some comparison shopping and considered all of your options? Because annuities are long-term savings vehicles, you’ll want to make sure the company you pick will be around at least as long as you will. And, as you learned in the previous discussion, different annuities offer a wide range of choices, prices, features and flexibility. 
• Does the rate on a fixed annuity look too good to be true? You want a competitive interest rate at renewal time. If the company is offering bonus rates (a higher interest rate for a set period of time) make sure the underlying interest rate is financially attractive, considering any additional contract costs or early surrender fees. Once the bonus rate term expires, you have no guarantee going forward that renewal rates will be competitive. Be especially careful if you are exchanging annuities. 
• What are the annuity’s surrender fees and how long are they in place? If the surrender fee is high (typical fees are around 6 to 7 percent and decline over a period of approximately five-to-seven years), you could find yourself locked into a contract from which it will be costly to escape. 
• What is the track record of the funding options offered in a variable annuity? Don’t be swayed by last month’s top performer. Look for strong returns over a three-to-five-year period or more. Newspapers such as Barron’s and the Wall Street Journal publish rankings of various funding options on a regular basis. The history of various funding options also can be found in Morningstar and Lipper Analytical Services publications. Remember, past performance is not a guarantee of future results. 
• Does a variable annuity offer multiple funding options in case you change your investment strategy a few years down the road? Look for a range of funds to diversify your retirement savings as your needs change.
• Will your ordinary income tax rate be greater than the current capital gains rate when you begin to take distributions (possibly at retirement)? If so, you may pay more in taxes by choosing annuities over another investment that would be taxed at the capital gains rate. Keep in mind, however, that your money in an annuity is accumulating on a tax-deferred basis. By selecting an annuity, you can avoid paying yearly ordinary income tax on the earnings while your money can compound and grow. 
• What is the insurance company’s rating? While anyone who is properly licensed to sell insurance products (e.g., banks, brokers, agents) can sell annuities, the insurance company issues the annuity contract. So, you’ll want to consider the company’s rating. Is it financially secure, with a good claims-paying record? While this is most important for fixed annuities, it is relevant to any guarantees (e.g., death benefit) in a variable annuity as well. Checking up on an insurance company is easy at your local library or on the Internet, or you can contact your state’s Department of Insurance. A.M. Best, Standard & Poor’s and Moody’s all rate the financial stability of insurance company general accounts. Morningstar and VARDs evaluate and report information on variable contracts only. Variable annuities are rated by independent sources such as Lipper Analytical Services, VARDs and Morningstar. It’s a good idea to choose an annuity from a company that gets high marks from at least two independent rating sources.