Surrender charges

Most annuities carry surrender charges. If you just bought the annuity, you are entitled to return it penalty free under state "free look" provisions. The free-look period generally does not exceed 10 days. Make sure you get a receipt for the policy from the agent dated within the free-look window.

If you are past the free-look period, you will have to check the policy to see how your surrender charges are imposed. The only rule of thumb you might rely on is that the higher the commission paid to the agent, the higher the surrender cost and longer the surrender period. For example, surrender charges might decrease 1 percent annually starting at 9 percent. Or, they might be level for seven years at 7 percent then drop to zero at the beginning of year eight.

If faced with a surrender charge, you might be inclined to hold the annuity until the charge expires. But you might be better off paying that fee and reinvesting in something more customer friendly.

For example, say you have a 7 percent surrender fee that decreases each year until it gets to zero. But you also realize that you could save 1.5 percent per year in expenses by bailing out of the contract. The total cost of the annual expenses over the next few years exceeds the surrender cost. It hurts, but you are better off swallowing hard and just doing it.

Income tax and penalty

Any gains you might have after paying off surrender fees will be subject to ordinary income tax upon withdrawal. Worse yet, if you are under age 59½, you may be subject to an additional 10 percent penalty tax on the gains.

If you have no gains, taxes won't be a problem. If your gains are small, you might be better off paying them now and investing the proceeds in a more tax-friendly fashion. But if your gains are large in proportion to your contributions, you might have to stay locked in. Even if you are, though, there is still some hope.

Section 1035 Exchange

The tax codes do allow you to exchange one annuity contract for another without having to pay taxes on the exchange.

Why would you want to do that? Because there are a few true no-load annuities with very low expenses and no surrender fees. For instance, a Vanguard Variable Annuity has a mortality and expense (M&E) charge of just 0.45 percent over the cost of the mutual fund itself. That might save you 1 percent per year in M&E expenses alone compared to the annuity you own. If you use their index funds inside the variable annuity, you might save an additional 1 percent per year in the fund's expense ratio. Saving about 2 percent per year adds up over any reasonable period of time.

Another good use of the 1035 Exchange provision is escaping a low-interest-rate fixed annuity that has a low basis. You can swap it for a no-load, no-surrender-fee, low-expense variable annuity like Vanguard's with a higher potential return.

Just open an account with Vanguard, TIAA-CREF, or any other company that has a low-cost, low-fee investment that you like and have it handle the transfer.

Remember, it's important that you not surrender the contract directly to take advantage of the Section 1035 Exchange provisions. Let the fund company do it for you.

Don't swap an annuity that has completed its surrender period for a new annuity. That will just cost you another commission and start a new surrender period.

And whenever you do a swap, just remember: No Load. No Surrender Fees. Low expenses.

Use in qualified plans and IRAs

There is no justification for using an annuity inside any qualified plan. The qualified plan itself provides the tax advantages and deferral. Because you can roll your contract into another qualified plan or IRA, you won't face a tax or penalty. (You might still have to deal with the surrender fee, if any.)

Section 403(b) plans

I have encountered many school teachers who believe that their Section 403(b) retirement plan must be funded with an annuity. That is absolutely not true. Many fund families, including TIAA-CREF and Vanguard, have qualifying plans.

Ask your administrator for a complete list of approved providers and then go with the mutual fund family with the lowest charges.