Variable annuities are sold more aggressively than fake merchandise on the streets of New York City. Thanks in part to commissions of 5% or more, sales of variable annuities have soared over the past decade.

But popularity is no indicator of practicality. The truth is, annuities only make sense for a fraction of the population. The rest of us should be buying plain old mutual funds. Of course, that's not easy to say to your dark-suited cousin who keeps taking you out for steak and Lafitte-Rothschild Bordeaux in hopes that you will sign on the dotted line. But, next time he invites you, you can bring along this article. Just make sure he pays the bill before you give it to him.

The Basics

First, a primer. A variable annuity is basically a tax-deferred investment vehicle that comes with an insurance contract, usually designed to protect you from a loss in capital. Thanks to the insurance wrapper, earnings inside the annuity grow tax-deferred, and the account isn't subject to annual contribution limits like those on other tax-favored vehicles like IRAs and 401(k)s. Typically you can choose from a menu of mutual funds, which in the variable annuity world are known as "subaccounts." Withdrawals made after age 59 1/2 are taxed as income. Earlier withdrawals are subject to tax and a 10% penalty.

Variable annuities can be immediate or deferred. With a deferred annuity the account grows until you decide it's time to make withdrawals. And when that time comes (which should be after age 59 1/2, or you owe an early withdrawal penalty) you can either annuitize your payments (which will provide regular payments over a set amount of time) or you can withdraw money as you see fit.

Fees, Fees and More Fees

Variable annuities are notorious for the fees they charge. Indeed, the average annual expense on variable annuity subaccounts (including fund expenses plus insurance fees) is typically more than a full percentage point more than on the average open-ended mutual fund. Unfortunately, variable annuity fees don't stop there. Many variable annuities act like B shares of mutual funds, paying commission from the ongoing fees; the average contract fee is $30 to $35.

What Death Benefit?

The death benefit basically guarantees that your account will hold a certain value should you die before the annuity payments begin. With basic accounts, this typically means that your beneficiary will at least receive the total amount invested even if the account has lost money. For an added fee, this figure can be periodically "stepped-up" or earn a small amount of interest. (If you opt not to annuitize, then the death benefit typically expires at a certain age, often around 75 years old.)

Investors who bought annuities and then died within the next two months probably got their money's worth. But considering the fact that over the long term the stock market will deliver positive returns, most folks need this insurance about as much as a duck needs a paddle to swim. While all variable annuities come with a standard death benefit, the average price for additional death benefits is 0.43%, according to Morningstar.

Surrender Fees

Another problem with most variable annuities is that your money is often locked up for several years typically five. Trying to withdraw funds during this time will result in huge fines. These fees typically decrease as the years tick by. For example, you might be charged a 6% surrender fee for a withdrawal during your first year of ownership. After seven years, however, that could be just 1%. The average maximum fee is a steep 5.94%, according to Morningstar.

Early Withdrawal Penalty

\As with most retirement accounts, if you withdraw funds before age 59 1/2, you'll be hit with a 10% early withdrawal tax penalty.

The Taxes

Gains in variable annuities are taxed at ordinary income tax rates. For most investors, that's a whole lot higher than the long-term capital gains tax rate they pay on their long-term mutual fund gains. And the tax difference can easily eat up the advantage of an annuity's tax-free compounding.

Residents of some states may pay even more taxes on nonqualified variable annuity accounts. (That is, accounts that are not purchased within an IRS-approved retirement plan like a 401(k), 403(b) or IRA.) Some states also add a tax for variable annuities purchased within a qualified account.

The World's Lousiest Estate-Planning Vehicle

There's no getting around the income tax due on annuities. In fact, if you die with money remaining in your annuity, your beneficiary will inherit all the taxes that you have deferred. Compare this to a mutual fund or ETF, whose basis is stepped-up at death. In that case, your beneficiary would owe no taxes on the gains. Both types of accounts annuities and mutual funds are liable for federal estate taxes on anything over the federal estate tax exemption.

Switch to a Low-Fee Variable Annuity

Now, if you've read all this and still want to buy an annuity, do yourself a favor and buy one with low costs and good investment options. Investors who already own run-of-the-mill high-priced annuities should consider a tax-free transfer called a 1035 exchange to a better quality, low-fee annuity. Just be sure to confirm that your surrender charges have expired before you make the switch.

For more on annuities: DIY annuities, annuities offer safety.