Definition and Example of a Variable Annuity
A variable annuity is a financial tool that is often used for retirement. It is similar to insurance: you pay the annuity company premiums for a period of time, and you are eventually entitled to regular payments that you can use as income in retirement.
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 from a variable annuity will vary, depending on the underlying performance of the investments you choose.
A variable annuity provides income payments for the rest of your life and thus protects you against the risk that you will live longer than the assets you have saved for retirement. It also protects you in the case of changes, such as a stock market crash, that could wipe out your other investments when you are no longer able to go back to work.
You can also designate your spouse or another person as the beneficiary of a variable annuity.
How Variable Annuities Work
To open a variable annuity, you make at least one purchase payment, similar to an insurance premium. You also designate when you want to start receiving payments.
During the accumulation phase of the variable annuity, your money can go into various investment choices that you select. Just as you would pick funds for a 401(k), a variable annuity offers options from a pre-selected list of funds, called "sub-accounts." Which sub-accounts you choose will depend on your risk tolerance and how long you have until you will begin taking payments. 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.
The investment options for a variable annuity are typically different kinds of mutual funds.
Insurance company annuities must also provide some form of insurance. Most annuity contracts guarantee that your initial investment will be paid out as a death benefit. Upon your death, even if your investments incur a loss, your named beneficiary will get 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 won't receive a 1099 tax form each year on interest, dividends, and capital gains from the variable annuity. You won't pay taxes on a variable annuity's gains until you start taking withdrawals. 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, if you trade in your lump sum of money for a guaranteed income stream from the insurance company.
Variable annuities are best suited for long-term investment, because you will have to pay large penalties if you withdraw money before a certain time period. This is known as the "surrender period." The fee typically decreases, the longer you have held the annuity. For example, you may have to pay a surrender fee of 10% if you make a withdrawal in the first year you hold the annuity, and then 9% in the second year. The surrender fee would decline by 1% each year for the first 10 years you hold it. After that, the surrender period would be over, and the fee would stop.
Your age can also affect whether it makes sense to withdraw funds early from your annuity. Because of an annuity's tax advantages, the Internal Revenue Service (IRS) also imposes an early-withdrawal fee. If you withdraw funds prior to reaching age 59 1/2, 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. These include:
- Death benefit: Provides benefits for your heirs after your death.
- Guaranteed minimum income benefit: Guarantees a minimum level of income payments, regardless of how your investments are performing.
- Preferred treatment on withdrawals: Applies to money used for long-term care expenses.
- Long-term care benefits: Pays for healthcare or nursing home care if you require it.
Each of these benefits requires additional payment and can reduce the value of your annuity. They also have the potential to provide important, needed income to you or your heirs. Like other forms of insurance, you must weigh whether the risks of paying for benefits you might never need outweigh the risk of needing benefits you don't have.
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. You would benefit from rises in the stock market. Of course, this feature can backfire. Your investments can also suffer from stock market declines.
Because these contracts often come with high administrative fees, the variable annuity investments will not perform as well as 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, so you wouldn'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.
- 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, so you will face penalties and fees if you withdraw money early.
- Variable annuities are not suitable for short-term financial goals.