What Is a Living Annuity and How Does It Work?

A variable annuity is a financial product designed to help individuals save for and manage retirement income. It operates as a contract between an individual and an insurance company, allowing for tax-deferred growth of investments. It provides a stream of income, often for life, with flexible investment choices.

Defining a Living Annuity and its Structure

A variable annuity, sometimes called a “living annuity,” is a post-retirement financial product enabling retirees to draw income. It has two primary components: an investment portfolio and income withdrawals. Unlike a traditional guaranteed annuity, a variable annuity allows capital to remain invested and subject to market fluctuations, offering potential for growth.

Funds are allocated to investment options known as subaccounts. These subaccounts resemble mutual funds, investing in stocks, bonds, or money market instruments. Its value depends on investment performance. This distinguishes it from traditional annuities, which offer fixed returns or principal guarantees.

A variable annuity progresses through two phases: an accumulation phase and a payout phase. During accumulation, an individual makes purchase payments, and funds grow on a tax-deferred basis, meaning earnings are not taxed until withdrawn. Investors can reallocate investments among subaccounts without immediate tax consequences. Once income begins, the annuity enters its payout phase, distributing periodic payments.

Variable annuities offer flexibility, allowing control over investment strategy post-retirement. This includes adjusting the investment mix and withdrawal rate. Keeping assets invested means the annuity’s value can grow over time, potentially managing inflation. However, the value is subject to market risk, and poor performance could decrease the annuity’s value and subsequent income.

Managing Income and Investment Within the Annuity

Variable annuities offer flexibility in managing income withdrawals. Many offer optional riders, such as a Guaranteed Minimum Withdrawal Benefit (GMWB). A GMWB allows a specified percentage of the initial investment or “benefit base” to be withdrawn annually for life, even if the account value declines. This provides a predictable income stream while capital stays invested. Payment frequency can be chosen (monthly, quarterly, or annually).

Income from a variable annuity can fluctuate based on underlying investment performance. Strong performance may increase the account value, allowing higher future withdrawals or extending fund longevity. Conversely, poor performance can reduce the account value, possibly necessitating lower withdrawals or increasing depletion risk. Policyholders can adjust their income withdrawal rate periodically, often annually, to align with financial needs and performance.

Individuals can select from diverse investment options within a variable annuity, known as subaccounts. Policyholders choose how purchase payments are allocated, creating a personalized investment strategy aligned with their risk tolerance and financial objectives. This control contrasts with traditional annuities, where the insurer manages investments without direct policyholder input.

Another key feature is the ability to reallocate funds among subaccounts without immediate tax implications. This allows individuals to adjust their investment strategy in response to changing market conditions or personal circumstances without incurring current taxes. For instance, one might shift from an aggressive stock-focused subaccount to a conservative bond-focused one as they age or if market volatility increases. Continued investment provides potential for long-term growth, significant for retirement planning.

Key Features and Associated Costs

Variable annuities include a death benefit feature, ensuring a specified amount is paid to beneficiaries upon the policyholder’s death. The standard death benefit guarantees beneficiaries receive at least the original purchase payments, minus prior withdrawals, or the current account value, whichever is greater. This provides financial protection for heirs.

Some variable annuities offer enhanced death benefit riders for an additional charge. These riders include a “stepped-up” death benefit, which periodically locks in the highest account value reached on certain anniversaries, ensuring beneficiaries receive the higher value. Another option is an earnings-enhanced death benefit, adding a percentage of earnings to the payout. These features increase the annuity’s cost but provide greater assurance for legacy planning. Beneficiaries can be individuals, trusts, or other entities, and their designation is crucial.

Variable annuities come with several costs. A common charge is the Mortality and Expense Risk (M&E) charge, which compensates the insurance company for assumed insurance risks like the death benefit and guaranteed income options. These charges range from 0.20% to 1.80% annually of the account value. Subaccount (investment) fees cover management and operational expenses of underlying investment options, typically ranging from 0.15% to 3.26% annually.

Administrative fees cover record-keeping and contract maintenance, often a flat annual fee ($30-$50) or a small percentage (0.10%-0.25%) of the account value. Many variable annuities also have surrender charges, penalties for withdrawing too much or surrendering the contract within a specified period (typically 5-10 years). These charges can start as high as 7%-8% in the first year and gradually decline. Optional riders for extra benefits, like guaranteed lifetime income or enhanced death benefits, incur separate fees, often ranging from 0.75% to 1.5% annually.

Taxation of Living Annuities

Income from a variable annuity is taxed as ordinary income. When distributions are received, investment gains are subject to the individual’s regular income tax rate, not capital gains rates. The principal, or original after-tax contributions to a non-qualified annuity, is returned tax-free. However, the IRS assumes earnings are withdrawn first from non-qualified annuities, meaning the taxable portion is distributed before the tax-free principal.

Investments within a variable annuity grow on a tax-deferred basis. Taxes on interest, dividends, and capital gains are not due until money is withdrawn. This tax-deferred growth allows assets to compound more efficiently than in a taxable account, where gains are taxed annually. However, withdrawals before age 59½ may incur an additional 10% federal income tax penalty, unless an exception applies.

For beneficiaries, tax implications of an inherited variable annuity depend on whether it was “qualified” or “non-qualified.” A qualified annuity is funded with pre-tax dollars, typically through retirement accounts like a 401(k) or IRA. The entire amount received by the beneficiary, including contributions and earnings, is taxable as ordinary income because no taxes were paid previously. Non-qualified annuities are funded with after-tax dollars, so beneficiaries only pay income tax on the earnings portion, as original contributions are returned tax-free.

Beneficiaries have choices for receiving the death benefit, influencing their tax liability. They can opt for a lump-sum distribution, subjecting the entire taxable amount to income tax in the year received, potentially pushing them into a higher tax bracket. Alternatively, they may stretch payments over their life expectancy or a five-year period, spreading the tax burden over several years. Spousal beneficiaries often have additional options, such as continuing the contract in their own name, preserving tax-deferred status.