Retirement planning is about building wealth to create income, and variable annuities are a financial tool designed specifically for that purpose. Variable annuities allow individuals to build wealth and create lifetime retirement income. However, they're not the right option for everyone.
Luckily, a local independent insurance agent can help you determine if a variable annuity is right for you. They can also help you shop and compare options from multiple carriers in your area. But first, you can use our guide to variable annuities and how they work.
What Is a Variable Annuity?
Annuities are policies issued by insurance companies that pay a regular income for life or for a set period of time. You can buy a variable annuity policy by making a single payment or a series of payments.
Variable annuity definition
A variable annuity investment income stream can rise or fall in value based on market performance. Variable annuities are often used to create a regular stream of retirement income. As such, they can be a riskier choice for many people than other retirement plans.
Types of Variable Annuities
Variable annuities are categorized as either deferred or immediate and qualified or non-qualified.
- Deferred variable annuities: These accumulate money for a period of time before the policy pays income to the insured.
- Immediate variable annuities: These start paying income to the insured right away.
- Qualified variable annuities: These are part of a pension plan or IRA and are purchased with pre-tax dollars.
- Roth-qualified annuities: These are part of a Roth IRA or pension plan and are purchased with after-tax dollars.
- Non-qualified variable annuities: These are personally owned and paid for with after-tax dollars.
If you want a variable annuity explained even further, an independent insurance agent is a great resource. They can walk you through all your variable annuity investment options to find the best fit.
How Do Variable Annuities Work?
Variable annuities have a selection of investments called subaccount funds, which are similar to mutual funds. Investors can choose from stocks, bonds, and other asset classes. The subaccounts accumulate money on a tax-deferred basis, and money can be transferred between subaccounts without any tax consequences.
Variable annuity performance changes periodically. The value of variable annuities is represented by units. The value of each unit rises and falls with the investment it represents.
The account value of a variable annuity rises and falls based on the value of the units, not because there are more units or fewer units. Variable annuity growth potential depends on the health of the current market and the outlook of the future market.
On the other hand, the value of fixed annuities is measured in dollars. When the value of a fixed annuity rises or falls, it's because there are more or fewer dollars in the account. This means that variable annuity returns are subject to change based on market performance, leading to a somewhat risky investment.
Why Choose a Variable Annuity?
You may decide to open a variable annuity account because of the many benefits it offers, such as:
- A menu of investment options: Variable annuities have a selection of investment options that suit many different objectives and strategies.
- Tax advantages: Capital gains and dividends are not taxed until money is distributed from the annuity. There is no tax on transfers between variable annuity subaccounts.
- Creditor protection: Most states offer annuities some form of creditor protection. In some cases, it is unlimited protection.
- Annuity options: Lifetime income based on investment performance, and guaranteed lifetime income options are available.
An independent insurance agent can help you determine if a variable annuity is right for you.
Optional Variable Annuity Features
With variable annuities, there are a few additional options to consider. These come in the form of riders.
- Guaranteed minimum income benefit (GMIB): This rider provides a minimum amount of lifetime income when they retire regardless of what the account value is. The minimum income is based on the original investment accumulated at an interest rate specified in the policy. Once the option is selected, the owner has no access to policy values.
- Guaranteed lifetime withdrawal benefits (GLWB): This rider provides a minimum amount of lifetime income when they retire regardless of the account value. Unlike the GMIB, the owner does have access to the account values. Withdrawing money in excess of the guarantee will reduce or eliminate the minimum income.
- Guaranteed minimum accumulation benefits: This rider guarantees a minimum account value regardless of investment performance. The minimum is usually 100% of the purchase payments after a seven- to 10-year holding period.
- Enhanced death benefit riders: These protect beneficiaries from down markets. The standard death benefit of a variable annuity is the account value.
Ask your independent insurance agent about optional riders that may enhance your variable annuity.
How Much Does a Variable Annuity Cost?
Fees and expenses for variable annuities can range from about 2% to over 4%. Some insurance companies offer low-cost "no frills" variable annuities for less than 0.5%. The typical fees and expenses are:
- Front-end sales loads: This is deducted from your purchase payment. Most products on the market today don't have a front-end sales load.
- Mortality and expense charges: These are asset-based charges for the cost of guaranteed annuity payouts and death benefits.
- Investment manager fees: These are charges for professional management of subaccount funds.
- Administrative fees: These are flat fees for transactions.
- Surrender penalties: Most variable annuities charge a fee if you cash in your contract or withdraw more than 10% of the cash value. Surrender penalties decline to zero over a period of years, usually not more than 10.
- Rider fees: These are asset-based charges for optional income and death benefit riders.
An independent insurance agent can help you find affordable variable annuity options near you.
Building Wealth in a Variable Annuity
Variable annuities are an affordable way for the average investor to take advantage of professional money management and diversification. Variable annuities usually have a wide selection of investment options to choose from. Stock funds, bond funds, real estate, and other asset classes are often on the menu. Mutual funds, of course, offer these options as well, so why is a variable annuity different?
Variable annuities are tax-deferred investment vehicles. There is no tax on capital gains and dividends until money is distributed.
For investors who regularly rebalance their portfolios between asset classes, tax deferral is important. That's because there is no tax when one investment is sold and another purchased. So, instead of the money going to the government, it stays in your account and continues to grow.
Variable Annuity Retirement Income
Variable income refers to the assumed rate of interest that insurance companies use to calculate the initial variable income payments from an annuity. The initial payment is calculated based on your age, sex, the assumed rate of interest, the account value, and the annuity income option that you select.
If the subaccount funds that you selected perform better than the assumed interest rate, your payment will be higher. If the performance of the subaccount investments that you selected is lower than the assumed interest rate, your payments will be lower. Variable lifetime income can be attractive for the investor who wants to keep up with inflation and is comfortable with the risk.
Guaranteed income refers to all of the annuity income options available as a fixed guaranteed income. The guaranteed lifetime minimum withdrawal benefit is available as a rider. The chart below summarizes common variable annuity income options.
| During Lifetime | At Death | Advantages | Disadvantages | |
|---|---|---|---|---|
| Life | Pays income for the annuitant’s life | None | Highest income | No refund of unused principal |
| Life and 10 Years Certain | Pays income for life, not less than 10 years | Balance if death occurs before the end of 10 years | Protection for beneficiaries | Lower income |
| Life and 20 Years Certain | Pays income for life, not less than 20 years | Balance if death occurs before the end of 20 years | Protection for beneficiaries | Lower income |
| Life with Cash Refund | Pays income for life, payments are at least a specified refund amount | Balance of refund amount | Protection for beneficiaries | Lower income |
| Period Certain | Pays income for a specified number of years | Balance of payments | Useful for certain planning purposes | Outliving income |
| Joint & Survivor 100% | Pays income for the longer of the two lives | No further payments on the second death | Surviving spouse continues to receive income for life | Lower income |
| Guaranteed Lifetime Withdrawal Benefit Single Life | Pays income for an annuitant’s life | Balance of account | Access to account values, death benefit | Income taxed as withdrawals |
| Guaranteed Lifetime Withdrawal Joint Life | Pays income for the lifetime of the annuitant and the second life | Balance of account at second death | Access to the account, death benefit | Income taxed as withdrawals |
Variable Annuity Taxes
Tax treatment for traditional qualified annuities, Roth-qualified annuities, and non-qualified annuities is different. The chart below summarizes the tax treatment of variable annuities.
| Non-Qualified | Qualified | Qualified/Roth | |
|---|---|---|---|
| Contributions | After-tax, unlimited | Pre-tax, limits for IRAs and qualified plans apply | After-tax, limits for IRAs and qualified plans apply |
| Growth | Tax-deferred | Tax-deferred | Tax-deferred |
| Surrender | Gain is taxed at ordinary rates. | All proceeds taxable | Tax-free |
| Annuity Income | Partially taxable at ordinary rates | 100% taxable at ordinary rates | Tax-free |
| Withdrawals | Withdrawals are gain first, gain is taxed at ordinary rates. | 100% taxable at ordinary rates | Tax-free |
| Loans | Loans are considered withdrawals; gain first is taxed at ordinary rates | IRA loans are not permitted; pension plans may have exceptions for home purchase and loans repaid in five years | IRA loans are not permitted; pension plans may have exceptions for home purchase and loans repaid in five years |
| Death Benefits | Gain is taxed at ordinary rates; proceeds will be taxed as "gain first" | Rules for inherited traditional IRAs and qualified plans apply | Rules for inherited Roth IRAs and plans apply |
| Sales | Proceeds in excess of the basis are taxed at ordinary rates | N/A | N/A |
| Penalties | 10% for withdrawals before age 59-1/2 | 10% for withdrawals before age 59-1/2 | 10% for withdrawals before age 59-1/2, penalty for withdrawals prior to the end of the fifth year |
What Happens to the Money in a Variable Annuity When You Pass Away?
If you pass away during the deferral period, your beneficiary will receive the account value. If you pass during the distribution period, the income option that you selected will determine what the beneficiary will receive.
Some companies offer a minimum guaranteed death benefit equal to the purchase payment. There are also optional riders to step up or increase the death benefit based on a formula. The formula can be the purchase payments accumulated at an interest rate, or the highest previous account value.
Is a Variable Annuity Right for Me?
Variable annuities are financial tools. Whether they are right for you depends on your investment goals. Here are some considerations:
- Retirement plans: Are you contributing the maximum to your employer's retirement plans?
- Tax-deferred growth: This is a major benefit of annuities. Is tax control important to you? Can you benefit from tax-deferred growth?
- Tax-free transfer: Transfer between subaccounts is ideal for investors who regularly rebalance their portfolios. Would you take advantage of this feature?
- What type of investor you are: Are you willing to take on the risk of a variable annuity when compared to other less risky options?
- Variable annuities have surrender and tax penalties: Do you have adequate resources for emergencies and other short-term needs?
- Variable annuities: These can guarantee an income for life. Do you want a fixed, guaranteed income instead of income that may benefit from market returns?
An independent insurance agent can also help you decide if a variable annuity is the best choice.
What Should I Look for in a Variable Annuity?
There are a few things to consider when selecting your variable annuity:
- Ratings: The financial strength of the insurance company is important. Review the carrier's official ratings with your independent insurance agent.
- Surrender charges: The surrender period is usually five to seven years. If it's longer, make sure you understand why. In any event, it should not be longer than 10 years.
- Fees and expenses: Fees and expenses with optional riders can be over 3%. Make sure you know what you are buying and why. Be sure to look at several companies and compare the fees.
Your independent insurance agent can help you make an informed choice when selecting the best variable annuity option.
Here's How an Independent Insurance Agent Can Help
Variable annuities can be an important part of your retirement plan. While they have many features and benefits, they are not for everyone.
An independent insurance agent can help you decide if a variable annuity is right for you. These agents have access to multiple carriers, so they're free to shop and compare variable annuity options for you. They'll get you matched to the right annuity at a great rate.
