Definition and Example of Variable Annuity
A variable annuity is a contract with an insurance company that provides income during retirement. It includes a self-directed variable investment component and an insurance component.
How Variable Annuities Work
To open a variable annuity, you pay at least one premium just like you would pay an insurance premium. You also specify when you would like to start receiving payments.
During the accumulation phase of a variable annuity, your money can go into various investment options you choose. Just as you select funds for a 401(k) account, a variable annuity provides options from a pre-determined list of funds called “sub-accounts.” The sub-accounts you choose will depend on your risk tolerance and when you plan to start receiving payments. The sub-account options include a variety of funds ranging from large-cap stocks to bonds, precious metals, and money markets.
Most variable annuities also have model portfolios you can choose from. You can set up your investments to rebalance automatically on a pre-specified schedule (such as annually or quarterly), or you can log in to your account online and redirect funds and investments as you wish.
Investment options for variable annuities are typically different types of mutual funds.
Insurance companies must also provide some type 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 have incurred losses, the named beneficiary will receive the original amount you invested (excluding any withdrawals you may have made). This benefit allows the annuity to qualify as an insurance contract.
Since it qualifies as an insurance contract, any investment gains are tax-deferred. You will not receive a 1099 tax form each year on interest, earnings, and capital gains from the variable annuity. You will not pay taxes on the variable annuity earnings until you start withdrawing funds. When you do, the distributions will be taxed as ordinary income.
Withdrawals are considered to come from earnings first, unless you convert your contract to guaranteed income from the insurance company.
A variable annuity is suitable for long-term investing because you will face significant penalties if you withdraw funds before a certain period. This is known as the “surrender period.” The fee typically decreases the longer you keep the annuity. For example, you might have to pay a surrender charge of 10% if you withdraw in the first year of owning the annuity, then 9% in the second year. The surrender charge decreases by 1% each year for the first 10 years you hold it. After that, the surrender period ends and the fee stops.
Your age can also affect whether it is appropriate to withdraw funds early from the annuity. Due to the tax advantages of the annuity, the Internal Revenue Service (IRS) also imposes a penalty on early withdrawals. If you withdraw funds before reaching age 59 and a half, you may incur a 10% penalty tax on any portion attributable to investment earnings. This is the same rule that applies to an IRA or 401(k) account.
Additional Features of Variable Annuities
Most annuities offer additional insurance riders that you can purchase. These include:
- Death Benefit: Provides benefits to your heirs after your death.
- Guaranteed Minimum Income Benefit: Guarantees a minimum level of income from payments, regardless of how your investments perform.
- Preferred Withdrawal Treatment: Applies to funds used for long-term care expenses.
- Long-Term Care Benefits: Pays for healthcare or care costs in assisted living facilities if you need it.
Each of these benefits requires an additional payment and can reduce your annuity’s value. They also have the potential to provide important and necessary income for you or your heirs. Like other forms of insurance, you should evaluate whether the risks of paying for benefits you may not need outweigh the risks of not having benefits you might need.
Is
Is a Variable Annuity Worth It?
One well-known benefit of variable annuities is that, because you can choose your own investments, you can potentially achieve higher long-term returns compared to fixed annuities. You will benefit from upswings in the stock market. Of course, this feature can also have downsides. Your investments can also be impacted by downturns in the stock market.
Since these contracts often come with high administrative fees, variable annuity investments may not perform as well as a portfolio of index funds in terms of overall return. However, some variable annuities may allow you or your spouse to receive specified payments for the rest of your life, so you won’t have to worry about outliving your assets.
Long-term investors (20 years or more) may benefit from using variable annuities to embrace fixed-income investments that will typically generate taxable income each year.
Nevertheless, many people may not take advantage of the tax-deferral benefits of variable annuities. Although the earnings will have accumulated tax-free, when you withdraw them, they will be subject to regular income tax rates, which are usually higher than the regular capital gains tax rates.
Key Takeaways
A variable annuity is a contract with an insurance company that includes the 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 funds early. A variable annuity is not suitable for short-term financial goals.
Source: https://www.thebalancemoney.com/what-is-a-variable-annuity-2389030
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