Learn the Definition of a Variable Annuity

A piggy bank with a stop watch.
Variable annuities can be defined by the combined insurance and investment components. Dimitri Otis / Digital Vision / Getty Images

A variable annuity, like any annuity, is a contract with an insurance company. There is both an investment component and an insurance component to this type of contract. Let's start by looking at the investment component.

The Investment Component

With a variable annuity, you get to choose how the money will be invested. The returns will vary depending on the underlying performance of the investments you choose.

This is why it is called a variable annuity. In comparison, with a fixed annuity you do not choose the investments; instead, the insurance company invests your funds and provides you with a specific guaranteed return, much like how a CD works.

You choose investments inside the variable annuity from a pre-selected list of funds (these funds are called sub-accounts inside of a variable annuity) which can range from aggressive stock funds to conservative bond funds. The sub-account choices may include blue-chip stock funds, international stock funds, small-cap stock funds, various types of bond funds, precious metals, balanced choices, and money markets. Most variable annuities also have model portfolios you can choose from.

You are usually able to set up your investments in the variable annuity so they automatically rebalance on a predetermined schedule (such as annually or quarterly), or you can log on to your account online and move investments around as you wish.

One of the touted benefits of a variable annuity is that, as you are able to pick your own investments,you could potentially achieve higher long-term returns than what a fixed annuity would pay. This feature can backfire - as due to the higher fees in many such contracts often the variable annuity investments perform worse than a portfolio of index funds

The Insurance Component

As a variable annuity is a contract with an insurance company, there has to be some form of insurance provided. Most annuity contracts guarantee the amount you invested will be paid out as a death benefit. This means if your investments incur a loss, and you pass away, your named beneficiary gets back the original amount you invested (less any withdrawals you may have taken). This death benefit allows the annuity to qualify as an insurance contract.

Since it qualifies as an insurance contract, any investment earnings are tax deferred. You do not receive a 1099 tax form each year on interest, dividends and capital gains from the variable annuity. Instead, you pay taxes at the time you take a withdrawal, and gains are considered to be withdrawn first. If you withdraw funds prior to reaching age 59 1/2 a 10% early withdrawal penalty tax may apply on any portion withdrawn that is attributed to investment earnings.

Investors in high tax brackets with long time frames (20 years or more) may benefit from tax deferral, particularly if they use the variable annuity to hold fixed income investments that would normally generate taxable interest income each year. 

Decades of tax deferral on the investment income that accumulates inside a variable annuity can make sense for those in high tax brackets now, particularly if they expect they will be in a lower tax bracket later in retirement.

Most folks, however, will not benefit from the tax deferral features of a variable annuity because eventually capital gains in the annuity will not be allowed to be taxed at the more favorable capital gain tax rate. 

Optional Benefits for Purchase

Most insurance companies offer additional insurance benefits you can purchase, such as death benefit riders, which can provide benefits for your heirs, and living benefit riders, which can provide guarantees as to how much income you can withdraw from the policy at a later date. Many variable annuities also offer preferred treatment on withdrawals for the purpose of long-term care expenses. These riders often have an associated fee - so you are paying to add on desired benefits to your annuity contract.

Is a Variable Annuity Right For You?

Investments should be bought as part of a plan.

If you understand what the purpose of the annuity is within your plan, then it may be a smart purchase. If you feel like you are being pushed into buying one, and the person selling it to you did not do a holistic plan, be cautious.