A variable annuity is a tax-deferred retirement vehicle that allows you to invest in a range of investment options, typically mutual funds, while providing insurance features such as death benefits and lifetime income guarantees.Unlike fixed annuities, which offer a guaranteed interest rate, the value of a variable annuity fluctuates based on the performance of the underlying investment options you choose.

This guide explores the mechanics, costs, tax implications, and benefits of variable annuities to help you understand this complex financial product.

The Basics of Variable Annuities

At its core, a variable annuity is a contract between you (the annuitant) and an insurance company.You make a lump-sum payment or a series of payments, and the insurer agrees to make periodic payments to you, either immediately or at a future date.

The Securities and Exchange Commission (SEC) defines a variable annuity as a security because of the investment risk involved. If the investment options you select perform poorly, you could lose money, including your principal. This distinguishes them from fixed annuities, where the insurance company assumes the investment risk.

The Two Phases of a Variable Annuity

Variable annuities operate in two distinct phases:

  1. The Accumulation Phase: During this period, you contribute money to the annuity. Your purchase payments are allocated to "sub-accounts," which function similarly to mutual funds. The value of your annuity grows (or shrinks) based on the performance of these sub-accounts. According to FINRA, any earnings during this phase grow tax-deferred, meaning you do not pay taxes on investment gains until you withdraw the money.

  2. The Payout (Annuitization) Phase: You can eventually convert your accumulated savings into a stream of regular income payments.You may choose to receive these payments for a specific period (e.g., 20 years) or for the rest of your life. The amount of each payment depends on the amount accumulated, your life expectancy, and the performance of your sub-accounts (if you choose a variable payout).

Investment Options: Sub-Accounts

When you purchase a variable annuity, you do not deposit money into a standard bank account. Instead, you allocate your premiums into separate accounts, often called sub-accounts.

  • Market Exposure: These sub-accounts invest in stocks, bonds, and money market instruments.

  • Risk and Reward: Because these are tied to market performance, they offer the potential for higher returns than fixed annuities, but they also come with the risk of loss.

  • Control: Contract owners typically have the flexibility to transfer funds between sub-accounts tax-free, allowing for portfolio rebalancing without triggering immediate tax consequences.

Key Features and Benefits

Variable annuities are often marketed for their insurance-wrapped features. These "riders" or guarantees distinguish them from standard brokerage accounts.

Death Benefits

Most variable annuities include a standard death benefit.If you pass away before you begin receiving income payments, your beneficiary is guaranteed to receive a specified amount—typically at least the total amount of your purchase payments, even if your account value has dropped due to poor market performance.Investor.gov notes that you can often purchase enhanced death benefits for an additional fee, which might lock in investment gains periodically.

Living Benefits (Optional Riders)

Insurance companies offer optional "living benefits" designed to protect your income while you are still alive. These usually come with extra annual fees:

  • Guaranteed Minimum Income Benefit (GMIB): Ensures a minimum level of income payments regardless of how your investments perform.

  • Guaranteed Minimum Withdrawal Benefit (GMWB): Guarantees you can withdraw a certain percentage of your investment annually until you have recovered your principal, regardless of market performance.

  • Guaranteed Lifetime Withdrawal Benefit (GLWB): Similar to GMWB but allows withdrawals for life.

Costs and Fees

Variable annuities are known for having higher costs compared to other retirement investments like mutual funds or ETFs. It is crucial to understand these layers of fees, as they can significantly drag down your net returns.

1. Mortality and Expense (M&E) Risk Charge

This fee compensates the insurance company for the risks it assumes under the annuity contract (e.g., the guarantee that you will receive income for life). According to FINRA, this charge is typically around 1.25% of your account value per year.

2. Administrative Fees

These cover record-keeping and other administrative expenses.They may be charged as a flat annual fee (e.g., $30) or a percentage of the account value (e.g., 0.15%).

3. Underlying Fund Expenses

These are the fees associated with the mutual funds (sub-accounts) you invest in. They are similar to the expense ratios you would pay for any mutual fund and typically range from 0.5% to 2% annually.

4. Surrender Charges

If you withdraw money from a variable annuity within the first few years (often 6 to 10 years), you will likely face a surrender charge. As described by MassMutual, these charges act as a penalty for early access to funds and typically decline over time (e.g., 7% in year one, 6% in year two, eventually reaching 0%).

5. Rider Fees

If you elect extra features like the GMIB or enhanced death benefits, you will pay additional annual fees, often ranging from 0.6% to over 1% depending on the complexity of the guarantee.

Tax Implications of Variable Annuities

Understanding the tax treatment is vital for determining if a variable annuity fits your financial plan. The IRS treats annuities differently than standard investment accounts.

Tax-Deferred Growth

You pay no taxes on the interest, dividends, or capital gains earned within the annuity until you withdraw the money.This allows your investment to compound faster compared to a taxable account where taxes are removed annually.

Taxation on Withdrawals

When you withdraw money from a variable annuity, the earnings are taxed as ordinary income, not at the lower capital gains rates that apply to most other long-term investments.

  • LIFO Rule: Withdrawals are treated on a "Last-In, First-Out" basis. This means the IRS assumes you are withdrawing your earnings (which are taxable) before your principal (which is not taxed). You will owe income tax on every dollar you take out until all the earnings in the account have been withdrawn.

Early Withdrawal Penalty

Similar to 401(k)s and IRAs, the IRS imposes a 10% federal tax penalty on earnings withdrawn before age 59½, in addition to standard income taxes.Northwestern Mutual highlights that exceptions exist (e.g., death or disability), but generally, liquidity is restricted.

Pros and Cons Summary

Pros

  • Tax Deferral: Investments grow without annual tax drag.

  • Lifetime Income: Can be converted into a guaranteed stream of paychecks for life.

  • Death Benefit: Protects beneficiaries from market downturns impacting the principal.

  • Unlimited Contributions: Unlike IRAs or 401(k)s, non-qualified annuities generally do not have annual contribution limits.

Cons

  • High Fees: The combination of M&E, admin, fund, and rider fees can exceed 2-3% annually.

  • Surrender Periods: Your money is locked up for several years; early access is expensive.

  • Tax Rates: Gains are taxed as ordinary income (up to 37%+) rather than long-term capital gains (typically 15% or 20%).

  • Complexity: Contracts can be dense and difficult to understand, specifically regarding rider restrictions.

Suitability: Is a Variable Annuity Right for You?

Variable annuities are generally considered most suitable for individuals who have already "maxed out" other tax-advantaged retirement options, such as 401(k) plans and IRAs, and are looking for additional tax-deferred savings space. They are also appropriate for investors who are willing to pay higher fees in exchange for guaranteed lifetime income and principal protection features that standard investment portfolios cannot offer. Conversely, due to high costs and surrender charges, they are rarely suitable for investors with short-term liquidity needs.