Key points on a  variable annuity

• · Tax treatment. Your gains in an annuity grow tax-deferred, but they are taxed as income when you withdraw the money. That contrasts with other investments such as stocks and mutual funds, which can qualify for lower capital gains treatments.
• · Penalties for early withdrawal. Variable annuities are designed as retirement savings vehicles. So, you pay a 10% federal tax penalty if you withdraw money before age 59?. Insurance companies typically levy surrender charges of their own if you withdraw more than 10% of your balance in the first few years. Surrender charges usually start at 7% of your investment and decline to zero over the next six to eight years. They can range, however, up to 16% and last for as long as 15 years.

• · Death benefit. Variable annuities typically come with a death benefit that ensures your heirs get back at least as much as you invested if you're unlucky enough to die while your investments are down. Your heirs will have other problems if you die owning an annuity, however. While most other investments get favorable tax treatment -- a so-called "step-up in basis" that eliminates or drastically reduces the taxes heirs must pay when they sell -- withdrawals from an annuity are taxed at regular income-tax rates.
• · Living benefits. Death benefits aren't the only insurance feature you can get with a variable annuity. Increasingly, insurers are pushing so-called "living benefits" or "life benefits," which guarantee that you can get back at least your original investment, usually compounded by a certain amount, when you withdraw the money in retirement. Investors stung by the bear market are greatly attracted to these guarantees, Carey said. That's helped fuel annuities' rise. Living benefits were available on 20 of the 25 top-selling variable-annuity contracts last year.
• · Costs. The insurance features of an annuity aren't free, of course. The typical annuity with just a death benefit costs 50% to 100% more in annual fees than comparable mutual funds. Life benefits can add 20% or more to that cost.
• Those extra expenses can seriously eat into your returns. Consider what would happen if you invested $5,000 a year in mutual funds with annual expenses of 1.5%, versus the same investment in an annuity with a 2.5% expense ratio. If the underlying investments returned 8% a year, after 30 years: