As bad as we think permanent or whole life insurance investment policies are (see Straight Talk on Life Insurance and Why We (Generally) Hate Cash-Value Insurance Policies), the insurance industry has done itself one better by coming up with annuities. The "variable" type of annuity in particular is a worse "investment" than many types of life insurance.

Here's what you need to know about annuities to avoid making a big mistake. Let's start with the basic question: What the heck is an annuity anyway?

An annuity is a contract, generally between you and a life insurance company. You typically enter into the annuity with a lump sum or series of premiums to pay. In exchange, you receive period payments (which can be fixed or variable) from the company and any profits you make on your invested money are usually tax-deferred. Many annuities also provide a death benefit to your beneficiary if you die.

There are three primary types of annuities:

1. Fixed annuities are ones in which your yield (the payments you receive) is guaranteed for a year or more. In an immediate fixed annuity, you invest a lump sum and start receiving payments on it right away. However, most annuities sold today are deferred annuities, meaning your payments are deferred for a period of time.

Many banks are big on fixed annuities, but that doesn't mean you have to be. They love to grab senior citizens out of line and sell annuities as an alternative to CDs. But be careful! This can be a big trap. The first-year or one- to five-year rate on some annuities will pay more than a CD, but here's the problem: A fixed annuity is a long-term investment, and it's not an alternative to a three-month to one-year CD. If you want to get your money back prematurely you're going to get hit with all kinds of penalties.

Here's the bottom line: Fixed annuities might make sense as a portion of your investment capital ONLY if you're looking for a safe investment that you don't have to touch for at least five years that will grow tax-deferred.

2. Variable annuities are essentially tax-deferred mutual funds. You have some choice in which mutual funds your annuity dollars are invested and your payments vary with the value of the account, which changes based on how the mutual funds you've selected are doing.

Here's some straight talk on variable annuities: Avoid them! We don't like them at all.

Invariably—no pun intended—these are sold to people who think they're paying too much in taxes and who are not happy with the current interest rate (yield) paid on fixed annuities. Sure, the pitch sounds appealing—you're getting a mutual fund investment and your earnings are tax-deferred.

But the annuity salesman often leaves out the most important point: If you're already paying too much in taxes, why defer the liability when you might pay more?! Plus, when you do take distributions out, all of your earnings get taxed as ordinary income whether you've held it in the annuity for one year or 101 years.

Variable annuities simply don't work. They're too expensive and when the market isn't doing well, they do worse than the average mutual fund because of all the expenses that come out.

Dolan Smart Money Move:Buy tax-free municipal bonds instead. You'll never pay taxes on the income and you'll avoid all of those money-draining expenses.

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