A variable annuity is a tax-deferred financial product that allows you to choose from a selection of investments — usually mutual funds that invest in stocks, bonds and money market instruments. An insurance company then pays you a retirement income stream determined, in part, by the performance of those underlying investments.
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Rachel Christian is a writer and researcher for RetireGuide. She covers annuities, Medicare, life insurance and other important retirement topics. Rachel is a member of the Association for Financial Counseling & Planning Education.Read More
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- Published: May 21, 2020
- Updated: July 6, 2023
- 5 min read time
- This page features 6 Cited Research Articles
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What Is a Variable Annuity?
A variable annuity is part investment and part insurance. Its rate of return fluctuates based on underlying investments you select.
In contrast, a fixed annuity provides a guaranteed interest rate — regardless of market performance.
Variable annuities are considered riskier than fixed or fixed-indexed annuities. If your selected investments decline, the value of your annuity also declines. This reduces your payout amount.
However, variable annuities offer the potential for higher returns and greater income than other annuity options.
When you purchase a variable annuity from an insurance company, you will choose from a selection of investments called subaccounts.
Mutual funds that invest in stocks and bonds are the most common investment option for variable annuities.
- Your principal
- Performance of investments
- Contract fees and other expenses
Your annuity contract can also be customized with optional riders at an extra cost. These insurance features offer a guarantee, such as the ability to make withdrawals up to a certain amount each year for the rest of your life.
Variable Annuities and Retirement
The most popular type of variable annuity is called a deferred annuity.
Deferred annuities delay your annuity payouts until a later date and give your money time to grow. They are often used as retirement planning tools because they provide a regular income stream after you exit the workforce.
Variable annuities are considered long-term investments. They aren’t meant to create a quick profit. That’s why early withdrawals from your annuity can cost you.
Variable annuities may be a good option for people who have already maxed out contributions to an IRA or 401(k) plan. Those retirement accounts offer tax-deferred advantages similar to annuities.
Benefits of a Variable Annuity
Like all financial products, variable annuities have pros and cons. It’s important to understand both before purchasing an annuity.
- Tax Deferred
- Gains are tax-deferred until you withdraw the money in retirement. Withdrawals are taxed as ordinary income, much like payouts from traditional IRAs.
- Longevity Protection
- Variable annuities let you receive periodic payments for a specified number of years — or the rest of your life. This feature can offset the risk of outliving your savings in retirement.
- Potential Inflation Protection
- Because of its growth potential, a variable annuity is more likely than a fixed annuity to outpace inflation.
- Investment Choices
- Variable annuities allow you to select your own underlying investments and choose from different levels of risk and potential growth.
- Death Benefit
- If you pass away before the payout phase, your beneficiaries may receive a guaranteed death benefit.
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Disadvantages of Variable Annuities
Because variable annuities are complex, it’s essential to understand some of the drawbacks associated with these financial products.
- Higher Risk
- Variable annuities are the riskiest annuity option. If your underlying investments perform poorly, you can lose money.
- Withdrawal Penalties
- If you withdraw too much money from your account ahead of schedule, you will face a surrender or withdrawal charge. This charge can be as high as 10 percent early in your contract. You may also have to pay a 10 percent tax penalty to the IRS if you take out money before the age of 59.5.
- Other Fees and Charges
- Variable annuities include several fees and expenses that may reduce your returns. They include administrative fees, mortality and expense risk charges, sale commissions and underlying fund expenses.
- No Guaranteed Return
- Unlike fixed and fixed indexed annuities, there is no guarantee that you will earn interest on your variable account. If your investment portfolio underperforms, it will impact the value of your annuity.
- Variable annuities are widely considered the most complex and difficult to understand type of annuity. The Financial Industry Regulatory Authority suggests asking your broker plenty of questions, including how long your money will be tied up as well as details on early withdrawal penalties and tax consequences.
6 Cited Research Articles
- Lankford, K. (2016, May). Variable Annuities: Guaranteed Income, With a Catch. Retrieved from https://www.kiplinger.com/article/retirement/t003-c032-s014-deferred-annuities-can-deliver-major-tax-advantage.html
- U.S. Securities and Exchange Commission. (2004, October 14). Variable Annuities - Free Look Period. Retrieved from https://www.investor.gov/introduction-investing/investing-basics/glossary/variable-annuities-free-look-period
- CNN Money. (n.d.) What is a variable annuity? Retrieved from https://money.cnn.com/retirement/guide/annuities_variable.moneymag/index.htm
- Financial Industry Regulatory Authority. (n.d.). Variable Annuities. Retrieved from https://www.finra.org/investors/investing/investment-products/annuities
- U.S. Securities and Exchange Commission. (n.d.). Variable Annuities. Retrieved from https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/variable-annuities
- U.S. Securities and Exchange Commission. (n.d.). Variable Annuities: What You Should Know. Retrieved from https://www.sec.gov/investor/pubs/sec-guide-to-variable-annuities.pdf
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