Even with today's simplified variable annuities, you need a good grasp of the pros and cons before putting part of your nest egg into one. Getty Images By Kimberly Lankford, Contributing Editor January 29, 2019From Kiplinger's Retirement Report After years of making variable annuities more complex and expensive, some insurers are offering products that have fewer bells and whistles, are easier to understand and have lower fees.QUIZ: How Well Do You Really Understand Annuities? Variable annuities were originally introduced decades ago as a tax-deferred way to save for retirement in mutual-fund-like accounts. But as more people gained access to 401(k)s, IRAs and other tax-deferred investments, insurers started to focus on providing income guarantees rather than just tax deferral—which became particularly popular after the 2007–09 market downturn. These income guarantees became expensive and complicated, however, and a lot of people didn’t know exactly what they were paying for. A few companies have gone back to basics and are offering low-cost annuities specifically for tax deferral. But there are pros and cons to this type of investment. Variable Annuities for Tax Deferral A basic variable annuity lets you invest in mutual funds with a tax-deferred wrapper. The fees, investment options and other rules can vary a lot by insurer. The average annuity open to new investors has fees of 1.23% per year, in addition to annual fund fees, according to Morningstar. Fidelity’s variable annuity has a 0.25% annuity charge plus fund fees, with 55 fund choices from a variety of providers. Vanguard’s variable annuity has 19 investment options and annuity fees of 0.27%, plus average fund expenses of 0.23%. Advertisement The average age of Fidelity’s variable annuity customer is 60. With the kids off in college, empty-nesters can accelerate their retirement saving with no limits on contributions, says Tim Gannon, vice president of product management for Fidelity Investments Life Insurance Company. There are no required minimum distributions from variable annuities. Having investments in the tax-deferred wrapper can also help you control your annual income, which determines if you’re subject to Medicare premium surcharges. It’s usually best to first max out all other tax-deferred savings options, such as 401(k)s, IRAs and health savings accounts, before investing in a variable annuity. But even then, the annuity isn’t necessarily the best choice. When you withdraw money from the annuity, it is taxed at ordinary income tax rates, rather than the lower capital-gains rates for investments held longer than a year in taxable brokerage accounts. “You have to look at your tax situation, your investment profile and how you like to invest,” says Gannon. You can be tax-efficient in a taxable account with mutual funds. But if you are a more active trader generating significant capital gains, “those are the clients that can benefit from the variable annuity,” he says. Consider how long you’d need to hold various investments in the annuity for the benefits of tax deferral to beat the lower fees and capital-gains tax rate of a taxable account. If you buy and hold a fund that invests in Standard & Poor’s 500-stock index, the holding period would need to be much longer than for a fixed-income fund that produces taxable income each year. “Wrap your tax-inefficient assets within the tax-deferred annuity, and take your tax-efficient assets and leave them outside of the tax-deferred structure,” says Craig Hawley, head of Nationwide Advisory Solutions, whose Monument Advisor investment-only variable annuity charges a flat fee of $20 per month. The Monument Advisor flat-fee annuity is available through financial advisers, and it has 350 fund choices and no surrender charges. In addition to the $20 per month, clients usually pay the financial advisers a fee to manage the money in the annuity—typically 1% of the assets under management. Advertisement Variable Annuities With Guarantees In recent years, insurers focused mostly on variable annuities’ income guarantees rather than tax deferral. Many people invested money from accounts that were already tax-deferred, such as IRAs, in variable annuities in order to guarantee a minimum level of income in retirement. These variable annuities are designed primarily for people who are 5 to 10 years away from retirement and who want to continue to invest in the stock market but are worried about what will happen if there’s a downturn right at the time they plan to retire. The fees for these guarantees vary widely by insurer, with total costs for the annuity averaging more than 3% when you add the guaranteed income rider, according to Morningstar. The calculations can be complicated. Even if your investment value drops, the guarantee locks in the “benefit base”—the amount that determines your level of guaranteed income—based on either a minimum amount every year, such as 5%, or the highest point your investments reach. But this is very different from an annual return, and you can’t withdraw the benefit-base amount in a lump sum. Instead, you can withdraw 5% to 6% of the benefit base each year for the rest of your life, no matter what actually happens to your investments. Many require you to invest in a balanced portfolio in order to get the guarantee. A few companies have tried to simplify the calculations and reduce the overall fees. Vanguard charges 1.2% for its guaranteed income rider, which locks in the highest anniversary value as the benefit base and lets you withdraw 5% per year if you start withdrawals between ages 65 and 79 or 6% per year if you wait until age 80 to start taking withdrawals. If you invest $100,000 and the value rises to $150,000 before falling to $120,000, your annual withdrawals will be based on $150,000. But if you cash out the annuity in a lump sum, you’ll only get $120,000. Vanguard lets you add or drop the guaranteed income rider at any time, but most variable annuities do not. “These would be for folks who want some participation in the market upside but want a guarantee around the withdrawals they can take,” says Danielle Corey, head of Vanguard annuity and insurance services. “It’s for folks who are getting closer to retirement. Because you’re trying to establish a high water mark, you wouldn’t want to pay for it for many years prior to retirement.” Advertisement SEE ALSO: 7 Common Annuities Mistakes (And How to Avoid Them) If you have a higher-cost variable annuity, you might consider rolling the assets to a lower-fee annuity through a tax-free “1035 exchange.” But first check if you would be subject to a surrender charge, which can cost up to 7% to 10% of your balance if you leave the annuity in the first 7 to 10 years. The income rider won’t transfer if you cash out or switch annuities, so be wary of giving up guaranteed income based on a benefit-base balance that is higher than your investment value.