Q. I've heard about annuities available through life insurance companies. How do they work? Can they be tied to an IRA, or must I invest directly through a life insurance company?

A. Annuities are life insurance products that may be purchased directly from a life insurance company or within an IRA. Any taxable profits will be treated as ordinary income rather than capital gains. However, taxes vary depending on how you purchase your annuity. If you work directly with the life insurance company, you will normally purchase the annuity with after-tax money. When you withdraw the annuity after age 59-1/2, you will pay tax on the profits, but not on the principal, which has already been taxed. (If you withdraw the annuity prior to age 59-1/2, however, you will pay tax on the profits plus a 10 percent penalty.) As you withdraw money from the annuity, you pay tax on the profit first and get a return on the principal last. If you purchase an annuity inside a traditional IRA, your initial investment is not taxed. When you withdraw the annuity, you will pay income tax on both the principal and the profit. A Roth IRA presents a third option. You invest with money that has already been taxed. Then, after five years, the Roth tax rules come into play and you will no longer pay tax on the profits when you withdraw. Of course, you'd still be subject to early withdrawal penalties of the annuity itself.

The management and the return on your annuity depend on which type you purchase. Some of the more common types are fixed annuities, variable annuities, or equity indexed annuities.

With a fixed annuity, your money is invested in the life insurance company itself; the company holds it as an asset. The annuity then serves as a basic savings vehicle. You will receive a fixed rate of return for a set number of years (for example, 6 percent for 5 years). At the end of that time, you can reset the rate, pull the money out, or roll it into a different fixed annuity. If you roll it over by doing a 1035 tax-free exchange, you might not have to pay any taxes on the transaction.

Variable annuities are managed by independent, mutual fund managers. It is still a life insurance product, but it is separate from the company's assets. This means that you can retrieve your money more easily if the company fails. Normally, you must leave your money in a variable annuity for a set period of time (often 7 to 10 years) to avoid penalties for early withdrawal. Variable annuities also offer some interesting riders. For example, they may guarantee your initial investment or even your initial investment plus 5 to 10 percent. A death benefit option can provide your beneficiaries with the highest value of your annuity over time, even if that value has decreased at the time of your death.

An equity indexed annuity generates returns that are tied to an index (Standard & Poor, Dow, etc.). You receive a percentage of the growth of that index. The percentage (such as 8 percent, 12 percent, or 18 percent) depends on the company from which you purchase the annuity. However, there is a guaranteed minimum rate of return (such as 3 percent), and there is normally a cap on the maximum, as well. Do your homework carefully before selecting an equity indexed annuity. There are usually long surrender periods (10 to 12 years), substantial penalties for early withdrawal (4 to 20 percent), and often high commissions and fees.