What Are the Best Variable Annuities?

A variable annuity is a contract between an individual and an insurance company, structured as a long-term investment product primarily designed for retirement savings. It provides tax-deferred growth potential and the opportunity for market-linked returns. Unlike traditional annuities with guaranteed returns, the value of a variable annuity fluctuates based on the performance of underlying investment options chosen by the contract owner. It also offers unique insurance features, such as death benefits and optional living benefit riders, which are not typically found in other investment vehicles.

Key Components and Features of Variable Annuities

Variable annuities involve several fundamental elements that define their structure and function. A core component is the investment subaccounts, which are essentially investment portfolios similar to mutual funds. These subaccounts allow contract owners to allocate their funds across various asset classes, such as stocks, bonds, and money market instruments, providing flexibility in investment strategy. The value of the annuity fluctuates depending on the performance of these chosen subaccounts.

Variable annuities often include various guaranteed living benefit riders for an additional cost. One such rider is the Guaranteed Minimum Withdrawal Benefit (GMWB), which ensures the policyholder can withdraw a set percentage of their investment annually, between 5% and 10%, regardless of market performance. This benefit provides a steady income stream, even if the account value declines due to market downturns. Another living benefit is the Guaranteed Minimum Accumulation Benefit (GMAB), designed to protect the initial investment by guaranteeing a minimum account value after a specified holding period, around 10 years. If the market value falls below this guaranteed minimum, the insurer makes up the difference.

Variable annuities also feature death benefit options, which provide a payout to designated beneficiaries upon the contract owner’s death. A basic death benefit guarantees that beneficiaries receive at least the amount of the purchase payments, minus any withdrawals, or the current account value, whichever is greater. Some contracts offer enhanced death benefits, which may include a “stepped-up” value based on the highest account value on specified dates or a percentage of earnings.

Costs and Fees

Variable annuities come with a range of fees and charges that can impact their overall returns. One significant charge is the Mortality and Expense (M&E) risk charge, which compensates the insurance company for the insurance risks it assumes, such as guaranteed death benefits and lifetime income guarantees. This charge is expressed as an annual percentage of the account value, ranging from 0.20% to 1.80%.

Administrative fees cover the costs associated with servicing and maintaining the annuity contract, including record-keeping and customer service. These fees can be a flat annual fee, such as $30 to $50, which may be waived for larger contract values, or a percentage of the account value, ranging from 0% to 0.60% annually.

Underlying fund expenses are charges associated with the investment subaccounts themselves, similar to mutual fund expense ratios. These fees cover portfolio management, trading costs, and other administrative expenses of the funds within the annuity. They vary by subaccount and can range from 0.15% to 3.26% annually.

Additional fees are charged for optional riders, such as guaranteed living benefits or enhanced death benefits. For instance, a Guaranteed Minimum Withdrawal Benefit (GMWB) rider costs between 0.5% and 1% per year, while a Guaranteed Minimum Accumulation Benefit (GMAB) rider can range from 0.30% to 1.00% annually. These rider fees are calculated as a percentage of the benefit base or account value.

Surrender charges may apply if withdrawals exceed a certain amount or if the contract is terminated within a specified period, ranging from six to ten years. These charges, used to cover sales commissions, are a percentage of the amount withdrawn and gradually decline over the surrender period.

Evaluating and Comparing Variable Annuities

Selecting a variable annuity involves a process of aligning product features with personal financial objectives and risk tolerance. Match the annuity’s specific riders and investment options to individual needs, whether the primary goal is guaranteed income, principal protection, or wealth transfer. For instance, individuals focused on lifetime income might prioritize annuities offering guaranteed lifetime withdrawal benefits.

A review of the annuity’s prospectus is a step in the evaluation process. This document contains information about the available investment options, all associated fees and charges, and the terms of any contractual guarantees. Understanding these details helps in comprehending the product’s mechanics and potential performance. The prospectus also outlines the financial strength of the issuing insurance company, which is a consideration as the guarantees are backed by the insurer’s claims-paying ability.

Comparing fee structures across different products is another aspect. This includes analyzing the mortality and expense charges, administrative fees, underlying fund expenses, and any rider fees. While some annuities might have lower base fees, additional riders can significantly increase the total cost. Evaluating the suitability and diversification of the underlying investment options is also important to ensure they align with an individual’s risk profile and long-term growth expectations.

The financial strength and reputation of the insurance company issuing the annuity warrant consideration. Insurers are rated by independent agencies, and reviewing these ratings can provide insight into the company’s ability to meet its future obligations. A strong financial standing provides assurance that the guarantees within the annuity contract will be honored. Engaging with a financial advisor can also be beneficial, as they can help analyze product details and assess how a variable annuity fits within an overall financial plan.

Taxation of Variable Annuities

Variable annuities offer tax-deferred growth during the accumulation phase, meaning that earnings are not taxed until they are withdrawn or income payments begin. This deferral allows the investment to potentially grow more efficiently, as earnings compound without annual tax deductions. Contributions to non-qualified annuities, those purchased with after-tax dollars, are not tax-deductible.

When withdrawals are made from a variable annuity, earnings are taxed as ordinary income, not at the potentially lower capital gains rates. This applies to both lump-sum withdrawals and periodic income payments. For non-qualified annuities, the Last-In, First-Out (LIFO) rule applies, meaning that earnings are considered to be withdrawn first and are therefore taxed before the return of the original, after-tax principal.

Withdrawals made before age 59½ may be subject to an additional 10% federal income tax penalty on the taxable portion, in addition to ordinary income tax. This penalty is similar to those found in other tax-deferred retirement accounts.

When the annuity is annuitized and begins paying out a stream of income, a portion of each payment is considered a tax-free return of principal, while the remaining portion is taxed as ordinary income. This is determined by an exclusion ratio, which calculates the percentage of each payment that represents a return of the original investment.

Upon the death of the contract owner, death benefits paid to beneficiaries are subject to income tax on the earnings portion. For non-qualified annuities, only the earnings are taxed, as the principal was contributed with after-tax dollars. For qualified annuities, such as those held within an IRA, the entire payout is taxable to the beneficiary, as the original contributions were pre-tax. Beneficiaries receive a Form 1099-R showing the taxable amount.