What Is a Variable Annuity?

Variable Annuities Explained

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A variable annuity is a contract with an insurance company that includes both a self-directed variable investment component and an insurance component. Its intended purpose is for retirement.

What Is a Variable Annuity?

Unlike a fixed annuity in which the insurance company invests your funds and provides you with a specific guaranteed return, a variable annuity lets you decide how the money is invested.

Returns of a variable annuity will vary depending on the underlying performance of the investments you choose.

How Variable Annuities Work

During the accumulation phase of the variable annuity, investment money goes into various selected investment choices.

Just as you would pick funds for a 401(k), a variable annuity gives investment choices from a pre-selected list of funds, called sub-accounts. Ranging from aggressive to conservative, the sub-account choices may include:

  • Blue-chip stock funds
  • International stock funds
  • Small-cap stock funds
  • Various bond funds
  • Precious metals
  • Balanced funds
  • Money markets

Most variable annuities also have model portfolios from which you can choose. You can set up your investments so they automatically rebalance on a predetermined schedule (such as annually or quarterly), or you can log in to your account online and redirect funds and investments as you wish.

Insurance company annuities must also provide some form of insurance. Most annuity contracts guarantee your initial investment will be paid out as a death benefit.

This means that, upon your death, even if your investments incur a loss, 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; in other words, you do not receive a 1099 tax form each year on interest, dividends, and capital gains from the variable annuity.

Because it is a tax-deferred account, you won't pay taxes on a variable annuity's gains until you start taking withdrawals. And when you do, the distributions will be taxed as ordinary income.

Gains are considered to be withdrawn first, unless you annuitize your contract—that is, you trade in your lump sum of money for a guaranteed income stream from the insurance company.

Are There Any Penalties?

If you withdraw money within a certain time period—in some cases as long as 10 years—you must pay a surrender fee, which is a sales charge.

If you withdraw funds prior to reaching age 59½, a 10% early withdrawal penalty tax may apply on any portion that is attributed to investment earnings. This is the same rule applied to an IRA or 401(k).

Types of Variable Annuity Add-ons

Most annuities offer additional insurance benefits you can purchase:

  • Death benefit rider: Provides benefits for your heirs
  • Living benefit rider: Guarantees how much income you can withdraw from the policy at a later date
  • Preferred treatment on withdrawals: Applies to money used for long-term care expenses.

Is a Variable Annuity Worth It?

One touted benefit of a variable annuity is that, since you can pick your own investments, you could potentially achieve higher long-term returns than with a fixed annuity—benefiting from rises in the stock market. Of course, this feature can backfire: Your investments can also suffer from stock market declines.

Also, because these contracts often come with high administrative fees, the variable annuity investments will perform worse than a portfolio of index funds in terms of overall return. Still, some variable annuities may let you or your spouse receive a set payment for the rest of your life, meaning you don't have to worry about outliving your assets.

Investors with long time frames (20 years or more) may benefit from using 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 to be in a lower tax bracket later in retirement.

Many folks, however, may not benefit from the tax deferral features of a variable annuity. While the earnings will have accumulated tax-free, when withdrawn they'll be taxed at your ordinary income tax rate, which is usually higher than the regular capital gains tax rates.

Key Takeaways

  • A variable annuity is a contract with an insurance company that includes investments you choose and a fixed insurance component.
  • It is designed to provide retirement income.
  • Still penalties can be incurred for early withdrawals.
  • Variable annuities are not suitable for short-term financial goals.