Variable annuities are commonly used to save for retirement, as they combine investing and long-term income payments into one product. They also operate on a tax-deferred basis, meaning you won’t have to pay income taxes until you begin withdrawing money in retirement. Insurance companies typically offer variable annuity contracts, so there are many different options available.
What Is a Variable Annuity?
An annuity is a contractual agreement that you enter into with an insurance company: In exchange for an upfront, lump-sum payment, you’ll receive a stream of regular income payments waiting for you. Most annuity companies allow you to pick from monthly, quarterly, semiannual or annual payments.
Variable annuities offer a number of investment opportunities that are designed to help your account grow. The financial makeup of a variable annuity is divided into two main components: the principal and the returns. The principal is the money that you yourself pay into the annuity. The returns are the income you make through investments. The time when you’re paying your principal and accruing returns on it is called the accumulation phase.
When you finally retire and are ready to begin receiving income payments, you’ll have to annuitize your contract. This is when payments start rolling in and your investments cease to earn returns. Upon reaching the payout phase, you likely won’t be able to make withdrawals outside of your annuity payments.Benefits of Variable Annuities
There are a wide range of investments that variable annuity contract holders can invest in. Most companies provide access to funds that offer professional investment management. These funds usually specialize in a specific type of security, like stocks, bonds and money-market instruments. They also adhere to varying risk tolerance levels and invest in specific areas of the market.
Tax-deferral is one of the primary perks of utilizing a variable annuity to save for retirement. This means you won’t owe federal income taxes on the money you earn with a variable annuity until you take withdrawals, receive income payments or a death benefit is paid out to a beneficiary. You can also shift your money between investment options within your annuity without paying taxes.
However, although investments are the core of a variable annuity, retirement payments are taxed at your regular income tax rate. This is as opposed to the lower capital gains tax rate. In turn, these tax-deferral benefits only outweigh the extra tax burden if you hold on to it as a long-term investment.How Much Do Variable Annuities Cost?
Like anything you invest in, there are costs associated with holding onto an investment, like 12b-1 fees. These charges often vary depending on the fund you invest in, so check each fund’s prospectus for more information. In addition to this, many annuity agents make commissions on the variable contracts they sell. For example, it’s not uncommon for an agent to earn around a 5% commission during these sales.
Insurance companies also charge their own fees. These come in the form of annual contract, administration and mortality and expense risk fees. Typically annual contract fees are flat-rate and waivable if your contract reaches a certain value. But administration and mortality and expense risk fees are unchangeable and are charged as a percentage of your portfolio‘s value.
Variable annuities normally operate on a term basis that might range from three years to ten. For the most part, life insurance companies will let you take out up to 10% of your contract value during this time period for free. But anything above that amount will encounter surrender fees that can reach as high as 10%. These charges decline annually, and once your term is over, they will disappear.Comparing Variable Annuities to Other Types of Annuities
Although both variable and fixed annuities are meant for long-term saving, the latter is a much safer bet. When you buy a fixed annuity, you get a guaranteed rate of return and a minimum payment at annuitization. This eliminates risk, which is music to the ears of risk-averse investors (and if you’re buying an annuity for guaranteed income, chances are you’re trying to manage risk). With variable annuities, contracts will fluctuate in value based on the performance of your underlying investments.
By contrast, indexed annuities are somewhat of a hybrid between fixed and variable annuities. These types of contracts offer annuitants the chance to invest in both a fixed account and an indexed account. The former adheres to a fixed interest rate that’s set by the insurance company. Conversely, the latter follows the performance of a market index like those from Standard & Poor’s (S&P) and Vanguard.
While indexed annuities earn returns in their own right, they still can’t match the potential of a variable annuity. This is due in large part to the fact that indexed annuities regularly come with rate caps that can limit what you gain.Bottom Line
Variable annuities are long-term savings products, so be prepared to hold on to them for a while. You should also avoid touching the money in your variable annuity before the age of 59.5, or you’ll be on the hook for a 10% IRS penalty on top of normal income taxes.
If you have questions about what kinds of investments to include in your variable annuity, a financial advisor may be able to help. These advisors specialize in investing and can help you figure out your risk tolerance so you’re happy with your portfolio and, eventually, your returns.Tips for Retirement Planning
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