Annuitizing a Variable Annuity: How It Works and What to Expect

A variable annuity is a long-term investment product that provides tax-deferred growth and the option to convert savings into a stream of income. Annuitization turns the accumulated value into regular payments, offering financial security in retirement. This decision is irreversible and affects both the amount received and the duration of payments.

Transition from Accumulation to Annuitization

When income is needed, the contract owner must decide whether to annuitize, surrendering control over the account balance in exchange for guaranteed payments. The insurer calculates these payments based on the contract’s value, the selected payout option, and actuarial factors such as life expectancy. Unlike the accumulation phase, where investment performance influences growth, annuitization locks in a formula that determines future income.

The timing of annuitization affects payouts. Starting earlier results in lower payments since they are expected to last longer. Delaying allows the account to grow, potentially leading to higher distributions. Some contracts require annuitization by a certain age, often around 85, at which point the insurer mandates conversion. Reviewing these provisions helps avoid unexpected changes.

Market conditions also impact payouts. Since variable annuities are tied to investments, the account’s value fluctuates. If the market is down, payments may be lower than anticipated. Some contracts offer a guaranteed minimum income benefit (GMIB), ensuring a baseline payout regardless of market performance, though this feature typically comes with additional fees.

Payment Structures

Annuitizing a variable annuity requires selecting a payment structure that determines how income will be distributed. Each option affects duration, potential benefits for beneficiaries, and overall financial security. This choice is permanent, so understanding the details of each structure is essential.

Life Only

The life-only option provides payments for as long as the annuitant is alive, with distributions stopping upon death. This structure typically results in the highest monthly income because the insurer does not account for payments beyond the annuitant’s lifetime. However, there is no provision for beneficiaries, meaning any remaining balance is forfeited to the insurance company.

This option may suit individuals without dependents or those prioritizing maximum income over leaving an inheritance. Payments are based on life expectancy, so younger annuitants receive lower amounts than older ones. For example, a 65-year-old annuitizing a $200,000 balance might receive $1,200 per month, while a 75-year-old with the same balance could receive $1,600 due to a shorter expected payout period. The insurer calculates these amounts using actuarial tables and interest rate assumptions, which vary by provider.

Period-Certain

A period-certain annuity guarantees payments for a set number of years, such as 10, 15, or 20, regardless of whether the annuitant is alive. If the annuitant dies before the term ends, the remaining payments go to a designated beneficiary. This structure balances income security with legacy planning, though monthly payments are lower than those of a life-only annuity.

For instance, a 20-year period-certain annuity on a $200,000 balance might provide $1,000 per month, compared to $1,200 under a life-only option. The insurer calculates payments by dividing the annuitized amount by the number of months in the selected term, adjusting for interest and investment performance. This option is often chosen by individuals who want to ensure a minimum payout period, particularly if they have dependents or financial obligations that extend beyond their lifetime.

Joint Life

A joint-life annuity provides payments for the lifetimes of two individuals, typically spouses. Payments continue until both annuitants pass away, ensuring financial support for the surviving partner. Because payments are expected to last longer, the monthly amount is lower than that of a single-life annuity.

Variations include 100% survivor benefits, where the full payment continues for the surviving spouse, and 50% or 75% survivor benefits, where payments reduce upon the first death. For example, a 100% joint-life annuity on a $200,000 balance might pay $1,000 per month, while a 50% survivor option could start at $1,100 and drop to $550 after the first death. This structure is often chosen by married couples who rely on annuity income for household expenses, ensuring financial stability for the surviving spouse.

Factors Influencing Payment Amount

Several financial and actuarial elements determine the amount received. One major factor is the interest rate environment at the time of annuitization. Insurance companies use prevailing rates to calculate payments, with higher interest rates leading to larger payouts. Insurers invest annuity premiums in fixed-income securities, and when yields are higher, they can pass along greater returns. Conversely, annuitizing during a low-rate period results in smaller payments.

Another key factor is the annuity’s subaccount performance. Unlike fixed annuities, where payments remain constant, variable annuities fluctuate based on the performance of underlying investments, typically mutual fund-like portfolios. If these subaccounts have experienced strong growth, the account balance at annuitization will be higher, leading to increased payments. Poor market performance reduces the balance, directly lowering distributions. Some contracts offer a guaranteed floor to prevent excessive declines, but this feature often comes with additional costs.

Fees and expenses also impact the final payout. Variable annuities carry management fees, mortality and expense charges, and administrative costs, which reduce the overall account value before annuitization. Riders, such as guaranteed income benefits or enhanced death benefits, further decrease the balance due to additional costs. Over time, these deductions can significantly lower the amount available for conversion into income. Reviewing the fee structure in advance helps in understanding how much of the investment is actually working toward future payments.

Impact on Tax Liability

Annuitizing a variable annuity changes how withdrawals are taxed, shifting from tax-deferred growth to a structure where each payment is partially taxable. The IRS applies an exclusion ratio to determine the portion of each payment that represents a return of the original investment, which is tax-free, versus the portion derived from investment gains, which is subject to ordinary income tax. This differs from other retirement income sources, such as qualified dividends or long-term capital gains, which are taxed at lower rates.

The tax treatment also depends on whether the annuity was funded with pre-tax or after-tax dollars. If purchased within a qualified retirement plan, such as an IRA or 401(k), the entire payment is taxable since no taxes were previously paid on contributions. For non-qualified annuities, only the earnings portion is taxed, with principal amounts excluded. This distinction affects after-tax income, as fully taxable payments reduce net cash flow more than those with a tax-free component.