A variable annuity is an investment, usually in mutual funds, that comes packaged with an insurance contract that let earnings grow tax deferred. However, variable annuities usually have very high fees and other charges that can wipe out the tax advantages, and then some.

You can buy a variable annuity with a lump sum or, more commonly, over time. You can allocate your investments among various mutual funds, called subaccounts, like you would in a 401(k) plan. Your return over time depends on how those mutual funds perform, which is why they are called variable.

When you begin withdrawing money, you pay ordinary income tax on the earnings portion and, if you are younger than 59.5, a 10 percent tax penalty.

Unlike a fixed annuity, a variable annuity generally does not guarantee a certain amount of income, although you can sometimes buy such a guarantee for an additional fee. The insurance contract embedded in the plan simply guarantees that the account will be a worth a minimum amount if you die before you begin withdrawing money.

There is no tax deduction for money you put in a variable annuity, nor is there an income or contribution limit.

It almost never makes sense to buy an annuity in a 401(k) plan, IRA or other tax sheltered vehicle, because you are paying extra for tax benefits you already have. It rarely makes sense to buy a variable annuity outside such a plan. To learn why, see http://www.nasd.com/InvestorInformation/InvestorAlerts/AnnuitiesandInsurance/VariableAnnuitiesBeyondtheHardSell/index.htm or http://www.smartmoney.com/retirement/investing/index.cfm?story=wrongannuities.