01 Dec Variable Annuities Explained
Variable annuities are a tax-deferred retirement vehicle to ensure you don’t run out of savings.
And, like other types of annuities, it’s a contract between you and an insurance company. The insurer agrees to make periodic payments to you, beginning either immediately or at some future date.
A variable annuity is an actual investment product that offers a range of investment options.
It is tied to the stock market in one form or another, and the investment options are typically mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three.
These options are sometimes referred to as subaccounts.
The value of your investment will vary depending on the performance of the investment options you choose.
Because variable annuities are tied to the stock market, they have a lot greater growth potential. And greater risk.
How Do Variable Annuities Work?
Variable annuities are used to accumulate funds for retirement. Once you reach retirement, you have several options to withdraw your funds, depending on the contract.
There are two main phases of a variable annuity: The accumulation phase and the distribution or payout phase.
This is the time period you deposit funds into the account.
You can drop in a lump sum at once, but it’s more common for people to deposit on a consistent basis – basically dollar cost averaging at a specific amount each month over the course of the contract.
During the accumulation phase, you make either a single purchase payment or a series of purchase payments.
Again, your contributions are invested in a portfolio of stocks, bonds, mutual funds, etc. (these portfolios are also known as subaccounts).
You can decide where to invest your contributions based on your risk tolerance.
Distribution or Payout Phase
Now that you’ve accumulated your wealth and have reached retirement, you have several options to take distributions.
These options depend on your specific contract.
Some of the normal distribution methods are:
You have a few options here:
- Lifetime – Receive payments for life.
- Joint and Survivor – Receive payments for life for both you and your spouse. If you pass away, payments will continue to your spouse.
- Period Certain – Receive payments for a certain period (continue for the 10, 20 years, etc.).
This is where you choose how much and how often you receive payments. Monthly interest withdrawals or a set amount each month are common.
Lump Sum Payments
This is not as common due to tax consequences, but this is where you take a lump sum all at once.
Variable Annuity Advantages
The biggest advantage is the tax-deferred status of variable annuities. No taxes are due until you withdraw funds.
Another is the growth of your portfolio based on the investments chosen inside your subaccounts.
This growth can also potentially outpace inflation, which is important right now because we’re in a high inflationary period.
Another advantage of fixed annuities is the potentially higher returns than you get with fixed rate annuities.
Variable Annuity Disadvantages
Investment Risk – The investments you choose could decline in value, which could lead to lower income payouts in the future.
Surrender Charges – Variable annuities are made for the longer term, and many have surrender charges (or early withdrawal penalties) as long as 15 years.
Penalties – Withdrawals before age 59½ will be hit with 10% penalties from the IRS.
Fees – The growth of a variable annuity can be held back based on the amount of fees inside it. Some normal fees seen inside this type of annuity are sales commissions, ongoing management fees, and costs of insurance charges. We have seen many of these with fees over 5%.
Also, variable annuities do not offer a guaranteed payout like with fixed annuities.
How Are Variable Annuity Withdrawals Taxed?
You do not pay taxes on any investment gains until you start withdrawals, and the earnings grow tax-deferred until withdrawn.
Then they are taxed as ordinary income when you withdraw funds.
Vary rarely do you see capital gains taxes in these products, unless the product was specific for estate planning.
Check Out This Video for More Info on Taxes and Annuities.
What Are the Death Benefits?
Most variable annuities pay a standard death benefit.
The initial premiums deposited could be the starting point and would lock in as the death benefit.
It could reset annually, to account for new highs in the account or new deposits, and not decrease except to account for withdrawals.
Each account may have their own specifics on death benefits, which is why it’s important to read the fine print of your contract BEFORE you sign it.
Make sure you set up a beneficiary on your account and review your beneficiary each year and update as needed.
Beneficiaries of a variable annuity could pay income taxes or capital gains taxes on their benefits, depending on how the contract is written. .
A benefit is that variable annuity payouts to beneficiaries do not have to go through probate.
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