Benefits of a Variable Annuity: What You Need to Know

Variable annuities have become a popular investment option for those seeking a combination of growth potential and retirement income security. With the ability to invest in diverse sub-accounts, these financial products offer benefits tailored to various investor needs.

Tax Deferral

A defining feature of variable annuities is tax deferral, enabling investors to delay taxes on gains until withdrawal, typically in retirement. This allows the entire balance, including earnings, to grow without immediate taxation, which can be advantageous for those in higher tax brackets during their working years. For example, an investor in the 35% tax bracket who anticipates retiring in the 24% bracket could achieve significant tax savings. However, withdrawals are taxed as ordinary income, and withdrawals before age 59½ may incur a 10% IRS penalty.

Investment Allocation

Variable annuities provide flexibility in investment allocation, allowing investors to design portfolios aligned with their risk tolerance, objectives, and market outlook. Sub-accounts, similar to mutual funds, span various asset classes like equities, bonds, and money markets, enabling diversification to manage risk while pursuing growth. Investors can reallocate funds without triggering immediate tax consequences, unlike taxable accounts. For instance, during a market downturn, shifting from equities to bonds may preserve capital, while reallocating to equities in a bull market could boost growth. Many annuities also offer automated rebalancing, maintaining the desired allocation without manual effort, appealing to those preferring a hands-off strategy.

Optional Death Benefit Features

Optional death benefit features in variable annuities can play a key role in estate planning. These benefits ensure beneficiaries receive a guaranteed amount upon the policyholder’s death, regardless of market performance. The standard death benefit guarantees at least the initial investment, minus withdrawals. Enhanced options, available for an additional fee, include the “stepped-up” benefit, which locks in the annuity’s highest value at a specified point, or the “annual reset,” which recalculates the benefit annually based on performance. While these features provide security, the associated costs can reduce returns. It’s important to evaluate whether these guarantees justify the expense and understand the tax implications for beneficiaries.

Income Payout Choices

Income payout choices in variable annuities are critical for retirement planning. Options include a life annuity, offering regular payments for the policyholder’s lifetime, which addresses longevity risk. Alternatively, a period certain annuity provides payments for a set number of years, useful for bridging income gaps or meeting specific financial milestones. Joint and survivor annuities extend payments to a surviving spouse, offering flexibility in structuring income based on individual needs and risk tolerance.

Fees and Charges

Variable annuities come with fees and charges that can impact returns. The mortality and expense (M&E) risk charge, typically 0.50% to 1.50% annually, compensates the insurer for contract risks. Investment management fees vary depending on the sub-account strategy, often exceeding 1% for actively managed funds. Optional features, such as enhanced death benefits or income riders, add between 0.25% and 1% or more annually. Transaction-related costs, like transfer fees, should also be considered. Evaluating these fees is essential to determine whether a variable annuity aligns with long-term financial goals. Comparing fee structures across products can help identify cost-effective options.

Surrender Periods

Surrender periods limit withdrawals during the initial years of a variable annuity contract, typically lasting 5 to 10 years. Withdrawals during this time may incur surrender charges, which start high and decrease over time. These periods allow insurers to recoup issuance costs. Aligning annuity choices with anticipated cash flow needs is essential to avoid unnecessary penalties. Some annuities offer waivers for surrender charges under specific circumstances, like terminal illness or long-term care needs. Understanding how surrender periods fit into broader financial strategies is crucial for balancing liquidity needs with the benefits of the annuity.