Uncle Sam wants us to save for retirement. That’s why variable annuities have special features and tax benefits. Where there are tax benefits, there are usually strings attached. Annuities are no exception.
So you want to know about variable annuities? Here’s everything you ever wanted to know, and maybe a little more.
First Things First.. What’s an Annuity?
Annuities are policies issued by insurance companies. They pay a regular guaranteed income for life or a period of years. You buy an annuity policy by making a single payment or a series of payments.
- Deferred annuities accumulate money for a period of time before the policy pays income.
- Immediate annuities start paying income right away.
- Traditional qualified annuities are part of a pension plan or IRA. They are purchased with before-tax dollars. Roth-qualified annuities are part of a Roth IRA or pension plan. They are purchased with after-tax dollars. Non-qualified annuities are personally owned and paid for with after-tax dollars.
Owners, Annuitants, and Beneficiaries
An annuity policy is a contract between the insurance company and these folks.
The owner has the sole right to the values and payments in the contract. The owner decides who the annuitant and beneficiaries are. The age and sex of the annuitant are how the insurance company determines the amount and when income is paid. The annuitant and owner don't have to be the same. The beneficiary receives the proceeds at the death of the owner or annuitant.
The insurance company issues the policy and has to honor the promises in it. Guarantees in the policy are only as good as the financial ability of the insurance company to pay claims.
How Does a Variable Annuity Work?
Variable annuities have a selection of investments called subaccount funds. Subaccount funds are similar to mutual funds. Investors can choose from stocks, bonds, and other asset classes. The subaccounts accumulate money on a tax-deferred basis. Money can be transferred between subaccounts without any tax consequences.
What Are the Features of a Variable Annuity?
Variable annuities have options for an additional charge that offer downside market protection.
- A guaranteed minimum income benefit (GMIB) rider provides a minimum amount of lifetime income when they retire regardless of what the account value is. The minimum income is based on the original investment accumulated at an interest rate specified in the policy. Once the option is selected, the owner has no access to policy values.
- Guaranteed lifetime withdrawal benefits (GLWB) provide a minimum amount of lifetime income when they retire regardless of the account value. Unlike the GMIB, the owner does have access to the account values. Withdrawing money in excess of the guarantee will reduce or eliminate the minimum income.
- Guaranteed minimum accumulation benefits guarantee a minimum account value regardless of investment performance. The minimum is usually 100% of the purchase payments after a 7-10 year holding period.
Variable annuities also offer enhanced death benefits to protect beneficiaries from down markets. The standard death benefit of a variable annuity is the account value.
- Creditor protection: Most states offer annuities some form of creditor protection. In some cases, it is unlimited protection.
How Much Does a Variable Annuity Cost?
- Front end sales loads: The front end sales load is deducted from your purchase payment. Most products on the market today don’t have a front end sales load.
- Mortality & expense charges: An asset based charges for the cost of guaranteed annuity payouts and death benefits.
- Investment manager fees: Charges for professional management of subaccount funds.
- Administrative fees: Flat fees for transactions.
- Surrender penalties: Most variable annuities charge a fee if you cash in your contract, or withdraw more than 10% of the cash value. Surrender penalties decline to 0 over a period of years, usually not more than 10.
- Rider fees: Asset-based charges for optional income and death benefit riders. Fees and expenses for variable annuities can range from 1.2% to over 4%. Some insurance companies do offer low-cost "no frills" variable annuities for less than .5%
How Do I Get Income from a Variable Annuity?
The assumed rate of interest is what insurance companies use to calculate the initial variable income payments from an annuity. The initial payment is calculated based on your age, sex, the assumed rate of interest and the accumulated value of your variable annuity. If the subaccount funds that you selected perform better than the assumed interest rate, your payment will be higher. If the performance of the subaccount investments that you selected is lower than the assumed interest rate, your payments will be lower.
The chart below summarizes variable annuity income options.
Guaranteed Income Options
|During Lifetime||At Death||Advantages||Disadvantages|
|Life ||Pays income for annuitant’s life||None||Highest income||No refund of unused principle|
|Life and 10 Years Certain||Pays income for life. Not less than 10 years||Balance if death occurs before the end of 10 years||Protection for beneficiaries||Lower income|
|Life and 20 Years Certain||Pays income for life. Not less than 20 years||Balance if death occurs before the end of 20 years||Protection for beneficiaries||Lower income|
|Life wIth Cash Refund||Pays income for life. Payments are at least specified refund amount||Balance of refund amount||Protection for beneficiaries||Lower Income|
|Period Certain||Pays income for a specified number of years||Balance of payments||Useful for certain planning purposes||Outliving income|
|Joint & Survivor 100%||Pays income for longer of two lives||No further payments at 2nd death||Surviving spouse continues to receive income for life||Lower Income|
|Guaranteed Lifetime Withdrawal Benefit Single Life||Pays income for annuitant’s life||Balance of account||Access to account values, death benefit||Income taxed as withdrawals|
|Guaranteed Lifetime Withdrawal Joint Life||Pays income for lifetimes of annuitant and 2nd life||Balance of account at 2nd death||Access to account, death benefit||Income taxed as withdrawals|
How Is a Variable Annuity Taxed?
Tax treatment for traditional qualified annuities, Roth-qualified annuities, and non-qualified annuities is different.
The chart below summarizes tax treatment of variable annuities.
|Contributions||After-tax. Unlimited||Pre-tax. Limits for IRAs and qualified plans apply.||After-tax. Limits for IRAs and qualified plans apply.|
|Growth ||Tax-deferred||Tax- deferred||Tax-deferred|
|Surrender ||Gain is taxed at ordinary rates.||All proceeds taxable||Tax-free|
|Annuity Income ||Partially taxable at ordinary rates||100% taxable at ordinary rates||Tax-free|
|Withdrawals ||Withdrawals are gain first. Gain is taxed at ordinary rates.||100% taxable at ordinary rates||Tax-free|
|Loans ||Loans are considered withdrawals. Gain first is taxed at ordinary rates.||IRA loans not permitted. Pension plans may have exceptions for home purchase and loans repaid in 5 years.||IRA loans not permitted. Pension plans may have exceptions for home purchase and loans repaid in 5 years.|
|Death Benefits||Gain is taxed at ordinary rates. Proceeds will be taxed as "gain firs.t"||Rules for inherited traditional IRAs and qualified plans apply.||Rules for inherited Roth IRAs and plans apply.|
|Sales ||Proceeds in excess of basis taxed at ordinary rates||N/A||N/A|
|Penalties||10% for withdrawals before age 59-1/2||10% for withdrawals before age 59-1/2||10% for withdrawals before age 59-1/2. Penalty for withdrawals prior to end of the 5th year|
What Happens to the Money in a Variable Annuity When You Die?
If you die during the deferral period, your beneficiary will receive the account value. If you die during the distribution period, the income option that you selected will determine what the beneficiary will receive.
Some life insurance companies offer death benefits that step up or increase based on a formula. The formula can be the greater of the purchase payments accumulated at an interest rate. The formula can also be based on the highest previous account value.
What If the Insurance Company Goes Bankrupt?
Insurance companies that sell variable annuities are regulated by each of the 50 state insurance departments. These departments have financial standards for licensed companies. Each state has guarantee funds to reimburse policyholders if the insurance company fails. The limits for each state are different.
Variable annuity products are regulated by the states, the SEC, and FINRA. The subaccounts in variable annuities are separate from the insurance company, and not subject to the claims of their creditors.
Financial ratings of insurance companies are available from A.M. Best, Fitch, Moody’s and Standard & Poor.
|Highest Ability To |
|Medium Ability To |
|Lowest Ability To |
|A.M. Best||A++ to A-||B++ to B-||C++ to C-|
|Moody’s||Aaa to Aa||A to Baa||Ba to Caa|
|S&P||AAA to A||BBB to B||CCC to C|
|Fitch||AAA to AA-||A+ to BBB-||BB+ to CC|
Is a Variable Annuity Right for Me?
Variable annuities are financial tools. Whether they are right for you depends on the job you want them to do. Here are some considerations:
- Tax-deferred growth is a major benefit of annuities. Is tax control important to you? Can you benefit from tax-deferred growth?
- Tax-free transfer between subaccounts is ideal for investors who regularly rebalance their portfolios. Would you take advantage of this feature?
- What type of investor are you? Are you willing to take on risk?
- Variable annuities have surrender and tax penalties. Do you have adequate resources for emergencies and other short-term needs?
- Variable annuities can guarantee an income for life. Do you want a fixed guaranteed income instead of income that may benefit from market returns?
What Should I Look for in a Variable Annuity?
The first concern for any type of annuity is the financial condition of the insurance company. The primary rating services that cover insurance companies are A.M. Best, Moody’s, Standard & Poor, and Fitch. Each has differences in their methodologies and rating designations.
The rating each service assigns reflects their opinion about the insurance company's ability to pay claims. A.M. Best is the only service that just covers insurance companies.
Look for high quality ratings from at least 2 of the 4.
Make sure you understand all of the fees and expenses. If you are adding riders, make sure you know what you are buying and why.
Variable annuities can be an important part of your retirement plan. While they have many features and benefits, they are not for everyone. Talk to your independent advisor. They can help you decide if a fixed indexed annuity is right for you.