How Does A Variable Annuity Work

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 8 minute read

Please give me a monetary gift, ideally in one single payment. When you’re older, I’ll pay it back in full (plus interest). Those sums may be paid to you indefinitely.

The offer seems too good to be true. Try again. This is the fundamental idea behind fixed annuities, a form of insurance that provides the purchaser with a steady stream of money in retirement. At the very least, the history of fixed annuities may be traced all the way back to the times of the Roman Empire.

In comparison, variable annuities are still in diapers. In the 1980s, yield-hungry Wall Streeters sought to spice up the boring annuity by adding some exposure to stocks (and risk).

A variable annuity, which depends on market performance, has the potential to outperform a fixed annuity, which offers a guaranteed but often modest rate of return. However, if the market were to fall, your earnings may be nothing. You should learn about how it functions, how it’s different from other annuities, and what advantages and disadvantages it may provide before you commit your life savings to one.

What Is a Variable Annuity?

You and the issuer, often an insurance company, enter into a contract when you buy a variable annuity. It is funded either with a single large payment or with installments spread out over a period of years, like other types of annuities.

Your investment in a variable annuity may grow over time, free from current taxation. However, unlike fixed annuities, variable annuities do not provide a minimum rate of return. 

Even if you make a contribution, there’s no assurance they’ll keep it safe. Though it’s quite unusual, it is possible to lose all of the money you invest in a variable annuity.

Variable annuities, like other kinds of annuities, promise monthly payouts beginning at some time in the future. An annuitization event occurs when you can no longer make payments to the contract or withdraw the value of the contract in any way, and then the payments begin.

This source of funding will be available for a set period of time. Insurance policies often provide lifetime income guarantees from the insurer. To the extent that you have designated beneficiaries, they may be entitled to the payments in the event of your death before the payments’ scheduled termination. You should expect your beneficiary to receive a death benefit from your annuity that is at least equivalent to your entire contributions if you pass away before payments begin.

Variable Annuities: How They Work

The value of your annuity contract determines how much you will get each year. This value is therefore a function of your initial investment, the length of time the contract has been in effect, and the growth of the assets owned under the contract.

Investments in Variable Annuities

The money you put into a variable annuity might be distributed across several different mutual fund accounts. The life insurance company will negotiate with a number of mutual fund firms to have one or more of their funds included under the contract, and the mutual fund firm will then set up a number of separate accounts for you to invest in.

Variable Annuity Taxes

When you put money into an investment account, you delay paying taxes on the earnings. Even if the annuity is not part of a tax-deferred account like an individual retirement account (IRA) or a qualifying plan like a 401(k) or 403(b) via an employer, it will still grow tax-free. A variable annuity can help you avoid paying taxes on the capital gains produced by your mutual fund investments each year.

However, you will have to pay taxes on the earnings from your annuity at some point. Before attaining age 59 12, you may be subject to a 10% tax penalty on the amount of any withdrawals you make. No matter when you take the money out, you’ll still have to pay taxes on the interest and dividends. Capital gains are taxed at a lower rate than ordinary income, yet the IRS levies profits at the higher rate.

The principal amount of each dividend from a variable annuity is tax-free. You will only be taxed on 80% of each income if you invest $100,000 in a variable annuity and the value of the contract increases to $500,000 upon annuitization.

In addition, most insurance companies will let you take off 10% or 20% of your annuity value annually before you turn 59 12 without a 10% tax penalty.

Payment Options for Variable Annuities

Variable annuity investors can choose from a variety of distribution strategies provided by insurance providers. If you want to set up a contract, you’ll need to pick at least one.

  • True to Form The easiest but riskiest choice is this one. Your insurance company uses actuarial estimates of your life expectancy to determine the amount you will get. Even if you live past the contract’s payoff, you will continue to receive annual payments. If you pass away before receiving the full amount of your account, however, your heirs will not get the remaining balance.
  • Coexist for the rest of your lives. By selecting this option and adding a co-beneficiary to the contract, you can increase the duration of payments and the total amount paid out by the contract. A spouse or domestic partner fits this description. In other words, as long as at least one of you is still alive, payments will continue to be made.
  • Period Certain Life. Payments can be spread out over a longer length of time than just life, usually at least five years but generally longer, to mitigate the danger of a lump sum payout for the rest of the beneficiary’s life. If you pass away before the term is over, the remaining payments will go to a contingent beneficiary, such as a child or other close family.
  • Cohabitation for a Predetermined Lifetime. With this alternative, you may designate a secondary beneficiary for your period-certain plan. If you’re married or have a domestic partner and want them to get money before any other beneficiaries, this is a good option.
  • Methodical Withdrawal. This choice establishes regular payments at a predetermined dollar or percentage rate. With an annuity, payments stop either when you pass away or when the fund is exhausted.
  • Lump-Sum. Last but not least, you might choose to immediately pay out your contract for the full value. You may put them back into the market as you choose.

Variable Annuity Benefits and Drawbacks

An attractive variable annuity is appealing to consider. You invest in an initial sum, earn returns comparable to the stock market while you wait, and receive regular payments in your old age. On the other hand, variable annuities come with some major negatives as well.

Benefits of Variable Annuity

When compared to fixed annuities, variable annuities offer a greater opportunity for development while still promising (but not guaranteeing) a steady stream of income for the rest of the contract holder’s life.

  1. Great room for expansion. Funds holding stocks and other assets with strong development potential are what variable annuities invest in. The potential upside of a variable annuity is greater than that of a fixed annuity, which provides a stable yet predictable rate of return.
  2. Lifetime income is a possibility. Like other types of annuities, variable annuities can provide a steady stream of payments for life, but do not guarantee it. That’s a tempting offer if you’re a retiree hoping to augment your income.
  3. Revenue Streams May Survive the Buyer. Your variable annuity may continue to pay out after your death if you set up a payout schedule that is long enough to cover their needs.
  4. Deferring Taxes for the Long Term Outside of a Retirement Account. To the extent that any annuity has tax advantages, variable annuities are no exception. The tax savings from an annuity can be substantial because there are no government-mandated contribution restrictions.

Drawbacks of Variable Annuity

When it comes to annuities, variable annuities carry the most potential danger. They are the priciest and their potential tax benefits may not be worth the price.

  1. Exorbitant Commissions and Service Charges. The cost of a variable annuity is significantly higher than that of a fixed one. Investing directly in mutual funds, or better yet, more tax-efficient ETFs, can save you from having to deal with the alphabet soup of fees and trailing charges that can hang around for years.
  2. Income Taxes Must Be Paid on Distributions. Distributions from an annuity are treated as regular income by the IRS, not capital gains. Withdrawals from an annuity will likely result in higher tax payments than distributions from a taxable brokerage account.
  3. The Risk of Sustaining Substantial Damage. When it comes to annuities, a variable annuity has the highest level of potential loss. Its worth is inextricably tied to the value of the underlying subaccounts, which are invested in stocks and other marketable securities. The value of your variable annuity will most likely decrease in tandem with the stock market.
  4. Liquidity issues. The funds in a variable annuity are not as accessible as those in a checking or savings account. Withdrawing funds from your retirement account prior to reaching age 59 12 will result in a hefty penalty.
  5. That’s not backed by the government. Contrary to bank account holdings, annuity balances are not insured by the FDIC or any other federal government agency. You risk losing everything if the insurance company that issued the policy goes bankrupt.

What is the cost of variable annuities?

The amount you invest into a variable annuity may be thought of as part of the total cost.
This sum will serve as the basis for your annuity payments. You can’t use it for anything else while it’s bound to the contract, and early withdrawals may incur steep penalties.

Variable annuities, on the other hand, are meant to be long-term investments that accrue value over time. Ideally, your investment decisions will yield a positive return on your principal, allowing you to build a sizable savings account to use in your golden years. On the downside, the value of that savings account will decrease over time as a result of taxes, inflation, and spending.

Bottom Line

High-quality insurance firms are trusted by investors to honor their end of an annuity deal. This is why annuity contracts are seen as secure investments.

In contrast to a fixed annuity, in which the initial investment and any subsequent growth and payments are guaranteed, a variable annuity might decline in value and may not even insure the initial investment.

To achieve results comparable to or better than those of the stock market over time, a variable annuity is your best chance. Of course, what rises may fall as well. Your lifetime income from your variable annuity may be jeopardized if its value drops significantly.

Maybe you and your loved ones may benefit from investing in a variable annuity. Be sure to seek the advice of a seasoned fiduciary financial advisor, though – someone who is not compensated financially for recommending that you purchase the annuity.

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