What is a Variable Annuity

Within the broad scope of investment options available in retirement, variable annuities stand out for their versatility. Essentially, they merge the guaranteed income feature annuities are known for with the potential for higher returns by linking the investment to the market. This blend of insurance benefits and investment potential can lead to a well-rounded financial strategy, especially for more daring retirees looking to make profits. Join us as we look into all the intricacies associated with variable annuities, including payouts, fees, benefits, taxation, and more, ultimately helping you make informed decisions for your financial future.

Key Takeaways

Variable annuities enable you to invest in numerous different asset options, providing the potential for growth based on market performance.

The initial contributions made to a variable annuity grow tax-deferred within the annuity, meaning taxes are not applied to the earnings until you make withdrawals.

Like most annuities, variable annuities allow you to convert the investment into periodic payments that can last for the rest of your life, providing a stable and consistent income during retirement.

Keep in mind that variable annuities come with associated fees, involving mortality and expense charges, administrative/management fees, and costs for additional features chosen, possibly impacting expected returns upon withdrawals.

Definition of Variable Annuity

A variable annuity is a financial investment for retirement that involves a contract between you and an insurance carrier. Upon signing the contract, you begin by making a lump-sum payment or series of disbursements to fund the annuity. In return, the annuity provider promises to provide you with a consistent income stream, either beginning right upon purchase or at a predetermined future date.

It is important to note that the total value and payout sum of a variable annuity is not set in stone and can fluctuate significantly over time depending on the performance of the investment options you choose. These options can entail a variety of mutual funds, be it stocks or even bonds, allowing you to customize your annuity based on risk tolerance and individual objectives.

Variable Annuities: Fees & Expenses

When considering a variable annuity, it is pivotal to understand the fees and expenses you may encounter upon purchase. Such costs can significantly affect your returns and should always be carefully reviewed. Let’s take a look at the main charges applied to variable annuities:

Important!

Be aware of the surrender period and fees associated with your variable annuity, as withdrawing funds early can result in extensive penalties.

Mortality and Expense Charges

Ranging from 0.4% to 1.75% of the account value per year (averaging around 1.25%), these charges compensate insurers for the risks they assume under the annuity contract, such as guaranteeing death benefits or providing lifetime income options.

Administrative Fees

Cover the insurance company’s costs related to maintaining the annuity contract, like record-keeping and customer service. They either represent a very minor percentage of the account value (do not exceed .30%) or have a set price, ranging from 30$-100$ a year.

Investment Management Costs

Charged by the individuals managing your market-linked investment options within the annuity. The sum of these fees may depend on the investment’s complexity but typically involves a percentage of the assets invested in each fund (ranging between 0.2% to 1% annually).

On top of these three main charges you may come across, it should be stated that other costs may apply in certain scenarios, such as surrender charges or rider fees. Surrender charges can be substantial but are only a concern in the case of early withdrawals. As for rider fees, they are applicable only if you opt for a rider, which is an add-on feature that can be added to annuity contracts for supplemental benefits.

Tax Regulations for Variable Annuities

One of the key benefits of variable annuities is its renowned tax-deferred growth, which implies that your investment grows tax-free until the annuitization phase. However, when you start making withdrawals during annuitization, one of two tax treatments will be applied depending on how the annuity was originally purchased (whether with pre-tax or after-tax funds). Regardless of the buying method, the earnings portion of the annuity’s value will be taxed as ordinary income. Additionally, withdrawals made before age 59 ½ will incur a 10% federal tax penalty.

Fast fact

Thanks to the tax-deferred growth feature of variable annuities, your investment can compound over time without direct tax implications.

Variable Annuities: Pros & Cons

Pros

Investment Flexibility: Given that you are the one deciding where your funds will be invested, you can tailor the investments to your risk tolerance. By spreading your lump sum across a variety of different investment routes, you can ensure further stability and minimize the risk of heavy losses.
Tax-Deferred Growth: Tax-free growth is applied until you withdraw funds, allowing your investment to accumulate over time without subjecting it to taxation.
Income Options: You can choose from several prominent payout options, allowing the income received to cater to your financial objectives in retirement.

Cons

Fees & Charges: It is important to acknowledge the various fees and expenses that may be applied to your lump-sum, potentially diminishing your returns.
Complexity: Variable annuities are often considered intricate financial products due to their fee structures, multitude of investment options available, and numerous features such as riders and payout options.
Lack of Liquidity: Since annuities are regarded as a long-term investment option for retirement, withdrawing funds early can result in significant penalties. Hence, liquidity before you reach withdrawal age is very limited.

Why Choose a Variable Annuity?

On the annuity spectrum, variable annuities stand as a suitable opportunity for individuals more prone to investment risk, looking for tax-deferred growth, yet still seeking a reliable income stream in retirement. By offering a unique combination of investment flexibility, profit potential, and various options for income distribution, these annuities may appeal to those aiming to balance growth and security in their retirement planning.

How Does a Variable Annuity Work?

Due to the multifaceted appeal of variable annuities, their functioning is often difficult to fully grasp for the average retiree. Luckily, we’ve got you covered, as we’ll take a look at how these financial products operate:

Investment Stage

To begin, a variable annuity is bought with a single lump-sum payment or through a series of periodic payments. You are offered the flexibility to distribute your premium across a range of investment options, such as stocks or bonds. Of course, the value of your variable annuity will then be linked to the performance of these underlying investments.

Accumulation Stage

During the accumulation phase, your investment grows tax-deferred within the annuity, accruing over time. In this period, you can also occasionally adjust your investment allocations to adapt to changing market conditions.

Annuitization Stage

This is the final stage of your variable annuity, as your account value is converted into a series of periodic payments. Since you are given various options for withdrawal, the exact sum and frequency of payouts will depend on your choice of distribution.

Payout Phase for Variable Annuities

The payout phase (also known as the distribution or annuitization phase) determines how you will receive the funds accumulated within your variable annuity. Understanding the choices available, as well as their implications, can help maximize your returns. Here are the principal payout options:

Lump-sum payment: Allows you to withdraw all funds at once, providing instant access to all your funds. However, this could cause a significant tax bill for that year and potentially expose you to the risk of longevity.
Lifetime income: Guarantees periodic payments for as long as you’re alive, providing a steady income stream in retirement. This is one of the most popular annuity withdrawal choices.
Joint and survivor option: Extends payouts to your spouse or another beneficiary after your death, ensuring continued financial support for your loved ones in the case of your passing.

What Should I Do Before Investing in a Variable Annuity?

Before you invest in a variable annuity, carefully consider your financial objectives, risk tolerance, and retirement needs. Let’s take a glance at some key steps to take prior to making a variable annuity contribution:

Understand the risks: Unlike other annuity types, variable annuities come with investment risks since they are linked to the market. This means your account value can fluctuate based on the performance of your underlying investments.
Evaluate fees and charges: Variable annuities typically come with various fees and charges associated, primarily including mortality and expense risk charges, administrative fees, and investment management expenses. It is important to review these supplemental costs and determine their impact on your overall returns.
Choose the investment options: Returns from a variable annuity are contingent on the performance of the subaccounts you select, making this choice vital. Assess the available investment options (subaccounts) within the variable annuity and pick one that aligns with your investment goals and risk profile.
Research providers/compare product offerings: Not all annuity providers/insurance companies are the same; ensure you look into the financial strength of your provider to guarantee they can fulfill obligations. Similarly, variable annuities can vary in terms of features, fees, and subaccounts available across different providers. Compare and contrast offerings from a few different insurers to find the best variable annuity for your unique needs.
Consider the time frame: Like most annuity types, variable annuities are a long-term investment for retirement planning, limiting liquidity. Consider your immediate financial needs before you invest, as early withdrawals are penalized.
Assess tax implications: Variable annuities come with tax advantages, largely characterized by tax-deferred growth, which allows your investment to accumulate within the annuity without being subject to taxation until withdrawals begin. Withdrawals are then taxed as ordinary income (exceptions may apply).
Review the contractual agreement: Look into the fine print of your annuity contract to avoid any unwanted surprises. Pay attention to surrender charges, withdrawal penalties, and any other details that could impact your returns.
Consult a financial expert: Seeking advice from a financial advisor may help determine if a variable annuity is suitable for your specific financial circumstances and goals. Moreover, an advisor can guide you through the variety of subaccounts available.

Bonus Credits

Certain variable annuities may offer bonus credits, which are additional amounts credited to your account when you make a purchase payment. Typically going from 1% to 5% of your initial contribution (depending on the specifics of your contract), bonus credits are essentially a percentage of your premium. For instance, a 5% bonus credit on a $100,000 annuity investment would add an extra $5,000 to your annuity investment. However, it should be noted that not all annuity plans offer bonus credits, and those that do may have a particular eligibility criterion, such as minimum investment amount or use of riders.

Additionally, bonus credits may come with strings attached; if funds are withdrawn early, for example, bonus credits may be subject to forfeiture. It is not uncommon for annuities offering bonus credits to also come with higher fees or longer surrender periods, making it crucial to weigh the value of your annuity with the bonus amount against the impact some of the aforementioned factors may have.

An annuity contract with bonus credits included should be evaluated thoroughly, as contracts may have clauses affecting their availability and calculation. Although appealing, bonus credits are often used as marketing incentives. Therefore, always ensure that the overall benefits justify the bonus, as you don’t want to be in a situation where higher fees end up causing a negative impact. If unsure how a bonus credit may influence your annuity’s returns, do not hesitate to consult with a financial advisor to determine if it aligns with your investment objectives.

Variable Annuities in 2024

With the ever-changing nature of investment options and market conditions, variable annuities are constantly evolving. In 2024, it is vital to look for new investment prospects, compare current interest rates, and be up to date about any potential changes in tax legislation that could affect your annuity.

Complementary Death Benefits & Other Features

Generally, variable annuities come with a death benefit, ensuring that your beneficiaries receive a predetermined amount if you were to pass away unexpectedly before receiving payouts. Moreover, many variable annuities offer other features like guaranteed minimum income benefits, which promise a certain payout sum regardless of market performance, and withdrawal benefits, allowing for more flexible access to funds. Such features can greatly enhance the value of your variable annuity, particularly providing extra protection for your retirement funds.

PRO tip

If you’re concerned about market volatility but still seeking higher growth potential, consider a variable annuity with a guaranteed minimum income benefit (GMIB) rider added to it for further income security.

Frequently Asked Questions About Variable Annuities

What happens to my variable annuity in the case of a market recession?

In such an occurrence, the total value of your annuity is likely to plunge with the market. This is the main reason behind variable annuity risk factors, making their returns far more unstable than other annuity types. However, certain riders can provide protection against market downturns.

Can I access my funds before I retire?

Funds can be accessed at any time, yet withdrawing before the age of 59 ½ or during the surrender period will incur surrender charges and tax penalties. Both can heavily impact your return of principal, limiting liquidity in the years after purchase.

Can variable annuities serve as short-term investments?

No, like most other annuity types, variable annuities are designed to be long-term investments for retirement.

How can I choose the right variable annuity?

Choosing the right variable annuity is a subjective matter that requires you to consider several factors. On top of aligning your choice with your retirement goals and risk tolerance, it is important to evaluate the annuity’s investment options, the reputation of the provider, and the specific features and benefits offered.

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