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Until four years ago, Paul Dasso, a 56-year-old shopping-center executive from Deerfield, Ill., crafted his retirement kitty around mutual funds, individual stocks and bank savings. Then, prompted by his insurance agent, Dasso added something new: Equi-Vest, a variable annuity offered by Equitable Life Assurance.

What sold Dasso was tax deferral and the opportunity for a souped-up return. A variable annuity is a hybrid of investment and insurance that is aimed at retirement savers; results depend on the performance of individual "subaccounts" within the annuity that are like mutual funds in a family of funds. Each subaccount has its own investment goal, and money can be switched from one subaccount into another without triggering tax. In fact, no tax is due until the investor takes money out, presumably at retirement. Gains get to grow tax-deferred because variable annuities contain an insurance component--a death benefit that guarantees heirs will get at least what the investor put in. That modest provision is why only insurance companies can issue annuities. Otherwise, however, the principal in a variable annuity is subject to market fluctuations-- in sharp contrast to a traditional fixed annuity, where the principal is guaranteed and earns a fixed rate of interest.

Successful strategy. Dasso doesn't plan to tap his annuity until well into his retirement and is comfortable with the prospect of short-term dips. Every month for four years, he has transferred money from a fixed-interest subaccount into three subaccounts geared to growth, aggressive growth and a balance of income plus modest growth. So far Dasso's picks have mostly beaten industry averages. He replenishes the fixed account sporadically; with Equi-Vest, he can do so at will. (Such "flexible premium" annuities are the most popular choice; "single premium" annuities are funded solely with an initial lump sum, while a few older annuities require regular premium payments.)

Dasso knows he can't cash in right away. If he wanted his money tomorrow, Equitable would take 6 percent off the top as a surrender fee charged on withdrawals of funds invested less than six years. The federal government would levy a 10 percent penalty, imposed on tax-deferred gains withdrawn before the investor turns age 59 . Finally, earnings on the entire amount withdrawn would be subject to tax. Investors younger than 59 can switch to another annuity without triggering the tax penalty or losing tax deferral but may still be hurt by the insurer's surrender fee. "I was very careful not to use funds I'd have to call upon soon," Dasso says.

Not all newcomers to variable annuities will be as prudent. Insurance agents, stockbrokers, banks, financial planners and mutual fund companies all are pushing annuities, capitalizing both on their familiar likeness to mutual funds and on their tax advantage in the wake of the recent hikes that created new tax brackets of 36 percent and 39.6 percent. Sales of variable annuities this year are running more than 40 percent ahead of 1992's record.

Like mutual funds, some insurance companies have hired high-profile money managers and are wooing investors with more options. The Best of America IV variable annuity offered by Nationwide Life Insurance now lays out 22 different subaccounts, ranging from international stocks to gold and natural resources. Big fund families like Fidelity, Dreyfus, Scudder and Vanguard are linking up with insurers and marketing annuities under their own names.

Stocks appeal? Bond-oriented investors looking for tax relief might want to bypass variable annuities in favor of municipal bonds or a no-load municipal bond fund, which has lower expenses and no surrender fee. It is the ability to invest in stocks while holding taxes at bay that gives variable annuities their special appeal. Historically, stocks have had far greater returns than bonds, so they can more quickly recoup annuity charges, which run an average of 0.75 percentage points a year ahead of mutual funds.

However, "the tax bill does not make variable annuities invested in stocks any more attractive than before," says Thomas J. Hakala, a partner at accounting firm KPMG Peat Marwick who generated an analysis at U.S. News's request. That contradicts many a sales pitch.

Understanding Hakala's conclusion calls for a bit of background. The tax bill left the 28 percent tax on long-term capital gains unchanged, and the gap between that rate and the new top income-tax rates of 36 and 39.6 percent widened considerably. The gap works against variable annuities, since much of stocks' returns comes from long-term capital gains while cashed-in gains from an annuity are taxed as ordinary income. Given enough time, tax deferral still gives annuities an edge over mutual funds, but the wait gets longer the lower your tax bracket; annuities usually don't make sense for people in the lowest 15 percent bracket. Hakala's calculations show that for investors in both the 31 percent and 36 percent tax brackets, it would take an annuity invested in stocks about 13 years to outpace a stock mutual fund after tax. Investors in the higher bracket would benefit from deferring taxes on dividends and short-term capital gains but would lose the lower long-term capital gains rate. The longer the funds are left to compound tax-deferred and the lower a retiree's income-tax rate when the money is withdrawn, the better the annuity will compare.

But no annuity should draw dollars away from tax-deferred retirement programs that make much more sense. Putting pretax salary into a 401(k) plan, especially since most employers at least partly match contributions, is simply unbeatable. If you qualify for a 401(k), putting after-tax dollars into an annuity is illogical unless you have already made the annual maximum pretax contribution to your 401(k) permitted by the government--$8,994 in 1993. (If your plan offers a good variety of investment options, you might want to contribute the maximum allowed by your company, typically 10 to 16 percent of salary, even if that involves using after-tax dollars.)

IRA option. Someone with no employer pension plan--or who belongs to a pension plan but earns less than $40,000 a year ($25,000 for singles)--can contribute up to $2,000 in pretax dollars to an individual retirement account, where earnings also compound tax-deferred. Even above that income level, it's wise to fund an IRA with the maximum annual after-tax contribution of $2,000 before looking to an annuity, because of the latter's higher fees. But the new tax bill does make it harder for some employees who earn more than $150,000 a year to accumulate money in 401(k) and other pension plans, by applying a complex ceiling to their contributions. Someone affected by the new rule might consider an annuity to make up the shortfall.

While a variable annuity can work as a retirement vehicle for some people, it is no way to leave assets to heirs. "An annuity is a tax bomb in an estate," says Michael Kiley, senior vice president at Guardian Life. After the owner's death, all gains are taxed as income. A variable-life insurance policy, a popular form of whole-life insurance that is also built around investment subaccounts, is a better deal for heirs. Annual costs are higher during the policyholder's life, but the entire death benefit is exempt from income tax, as with all life insurance policies.

For those who might want to consider a variable annuity, choosing the right one and following its performance have become easier than in past years. Morningstar's Variable Annuity/Life Performance Report (800-876-5005, $55 a year quarterly, $125 monthly, $15 for one issue) gives current and historical performance and cost data on 1,400 annuity subaccounts. Each issue of Barron's, the Wall Street weekly, includes statistics on annuities, but they work better for checking current performance than for comparison shopping since total returns go back only 52 weeks; at least a three-year history is preferable.

Defusing charges. The best annuities feature both good performance and reasonable expenses; the steady drip of fees and charges can erode the return of even superior stock picks. Performance figures should reflect expenses, and total annual expenses should fall below 2 percent, the rough average for all annuities. The total includes a customary flat annual fee of $30 or so, the management expenses charged by the individual subaccounts and the insurance expense for the death benefit.