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If you're stuck with an expensive annuity that's costing you too much, here are the least expensive ways to get out.

Question: I have invested in a variable annuity for the past three years, but my account’s value isn’t growing much at all. I also recently found out that annuities have commission fees and annual charges. I'm in my late 20’s so I still have a long road ahead of me. I would like to convert my variable annuity to a Roth IRA. Is that possible? And what would be the least expensive way to do this? —Chasity Williams, Fairview Heights, Illinois

Answer: What’s that? You’re perplexed about the myriad fees levied by your variable annuity and you’re having doubts about whether it’s an appropriate investment for you?

I’m hardly surprised. Variable annuities have long had a reputation for ranking among the most expensive and confusing investments around. A reputation that’s well deserved in my opinion.

Regulators and the insurance industry have been jabbering for years about improving fee disclosure and suitability requirements, and continue to do so. But aside from improvements at the margin, fees largely remain bloated, disclosure is lousy and thousands of investors who have no business in annuities continue to get sucked into them, unaware of what awaits them.

But enough about the failure of regulators and the insurers and brokerage firms that sell annuities to get their act together. Let’s get to your question.

At heart, what you really want to know is what can you do with a variable annuity you no longer want.

I’ll start with whether you can convert the variable annuity to a Roth IRA. The answer: it depends.

You can’t just move money from any investment into a Roth IRA (or regular IRA, for that matter). In order to roll over money in an investment - whether it’s an annuity, a stock, a bond, mutual fund, whatever - to a Roth IRA, that investment must already be held in a regular IRA account. (Money from investments held in 401(k)s and similar retirement accounts may also qualify for a Roth conversion or IRA rollover, but it doesn’t sound as if that’s the situation you’re dealing with.)

Inside an IRA

So the first thing you’ve got to do is call the person who sold you the annuity or check your account statement to see whether you own the annuity within an IRA account.

If that’s the case, then it’s a pretty simple matter to convert your annuity stash to a Roth IRA, where you can invest it in something other than an annuity, such as mutual funds. (You would be selling the annuity within the IRA and then converting the proceeds to a Roth where those proceeds would be reinvested.)

You’ll have to meet the income eligibility requirements for a Roth conversion, although even that hurdle will disappear in 2010. And you’ll likely have to pay income tax, which is almost always the case when you convert a regular IRA to a Roth (as opposed to rolling over your money to another regular IRA, which wouldn’t trigger any taxes). But essentially the process is the same as converting money invested in mutual funds in a regular IRA to a Roth IRA. The mutual fund or brokerage fund firm you’re opening the Roth IRA with can help you with the rollover.

Outside an IRA

But if you own this annuity outside an IRA account, then you can’t roll it over into a Roth IRA. That has nothing to do with the fact that it’s an annuity. The same is true for mutual funds or any other investment held outside an IRA account. You can’t just move non-IRA funds into a Roth IRA (or a regular IRA, for that matter).

I think people get confused about this because at some level they equate variable annuities with IRAs. After all, investment gains in variable annuities, like those in IRAs, are sheltered from taxes until you withdraw your money. But an IRA is a type of account that can hold many different types of investments. A variable annuity, on the other hand, is an investment vehicle. Just because a variable annuity shares a feature with IRAs - i.e. tax deferral - doesn’t mean you have the same rollover and conversion options with a variable annuity as you do with an IRA.

So given all this what should you do with your annuity?

Well, if you did indeed buy your variable annuity within an IRA account, then you should definitely consider converting it to a Roth IRA or, for that matter, rolling it into a non-annuity investment in a regular IRA. Either way, you’ll be able to invest at a lower cost than what you’re paying in the annuity.

Paying the price

But before you start the conversion or rollover process, you’ll want to see if you still face surrender charges in your variable annuity. These fees can start at 10% or more in the early years and usually take seven to 10 years to disappear. So if getting out of your annuity now would cost you a bundle in withdrawal charges, you might want to hold off until the surrender fees disappear or fall to a less onerous level.

If you own the variable annuity outside of an IRA account, you can’t do an IRA rollover or Roth conversion. But I still think you ought to consider getting rid of the annuity.

To do so, however, you’ll not only have to look into surrender charges, but taxes and penalties too. Specifically, if you sell, any investment gains generated by the annuity will be taxed at ordinary income rates, which can run as high as 35%. (That, by the way, is true even if those gains are long-term capital gains, which normally would be taxed at a maximum rate of 15% in stocks, bonds and mutual funds.) In addition, since you’re under age 59 1/2, you’ll also owe an additional 10% penalty tax on any gains.

You say your account’s value isn’t growing much, so maybe you don’t have sufficient gains for this to be a big issue. And since you’re so young, you’ve also got plenty of time to recoup taxes and penalty charges with the higher returns you should be able to earn in an investment that doesn’t have an annuity’s extra fees and that gets better tax treatment on long-term capital gains.

Of course, if you do sell a variable annuity held outside an IRA, you could take whatever money remains after taxes and surrender charges and put up to $5,000 of it into a Roth IRA ($6,000 if you were 50 or older). That assumes you have earned income at least equal to the amount you put in the Roth, and that your income doesn’t exceed the threshold for Roth contributions.

But if you do this you wouldn’t be “converting” your annuity money to a Roth. You would just be making a plain old annual IRA contribution. Provided you have enough earned income to qualify, the IRS doesn’t care whether the actual dollars for an IRA contribution come from your paycheck, proceeds from the sale of an investment or any other legal source for that matter.

Sidestepping penalties

If, on the other hand, you have an annuity with significant gains but are leery of selling it and paying taxes and (possibly) penalties, there is another way to go. You can switch to another annuity that has lower charges.

You’ll still have to watch out for surrender charges. And to avoid triggering taxes in this switch, you don’t want to just sell your annuity and reinvest the proceeds. You want to do what’s known as a “1035 exchange.” The company you’re getting the new annuity from can help you with the paperwork and the transfer.

If you go this route, you’ll still be in a variable annuity. But at least you’ll be in one that’s siphoning off less in fees.

If nothing else, I think your situation reinforces the point that variable annuities are generally a lousy way to accumulate money for retirement (although certain types of annuities may be able to play a role in providing retirement income. Variable annuities are complicated, usually inordinately expensive, tax-inefficient - and they’re a pain in the neck to dump.

Who knows, maybe at some point the regulators and the insurance industry will come up with decent disclosure that levels the playing field a bit for individual investors. In the meantime, I recommend that anyone considering investing in a variable annuity check out the E-Z disclosure form that I’ve proposed and then proceed with a very high degree of skepticism before committing a single cent to one of these complex and confounding investments.