Variable Annuities: Advantages and Disadvantages

(Discover all of the pros and cons)

Reviewer: Jeffrey Green Written by Jeffrey Green
Reviewer: Jeffrey Green
Written by Jeffrey Green

Jeff Green has held a variety of sales and management roles at life insurance companies, Wall street firms, and distribution organizations over his 40-year career.  He was previously Finra 7,24,66 registered and held life insurance licenses in multiple states. He is a graduate of Stony Brook University.

Advantages and disadvantages of variable annuities

Variable annuities are a popular retirement savings vehicle. In fact, in 2018, Americans bought almost $93 billion of variable annuities. That's because variable annuities have many valuable features to protect retirement assets. Of course, nothing in the investment world is free, and these features come at a cost. There's no shortage of strong opinions, for and against. So here they are, the top advantages and disadvantages of variable annuities. 

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Top Advantages

Professional money management: Variable annuities have a selection of professionally managed investment options called subaccounts that suit many different objectives and strategies.

Tax-deferred growth: There is no tax on subaccount capital gains or dividends until there are distributions, and also no tax on transfers between subaccounts. 

Lifetime Retirement Income: Variable annuities have income options that can pay for one lifetime or the longer of two lifetimes. The payments can be a fixed amount, or can rise and fall with investment performance. 

Unlimited contributions: Non-qualified variable annuities have no contribution limits, unlike IRAs and qualified plans.

Downside Protection: Variable annuities have living benefits that protect retirement assets from unfavorable markets. Living benefit features have additional charges. 

Death benefits to protect beneficiaries: The standard death benefit of a variable annuity is the account value. There's no charge for the standard death benefit.

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.

There is a charge for this feature.

Creditor protection: Most states offer annuities some form of creditor protection. In some cases, it is unlimited protection. This feature can be important for people in high risk occupations like attorneys, physicians, and corporate executives.


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Top Disadvantages

Variable annuities can be expensive: Depending on the insurance company and features selected, the fees and expenses can be upwards of three percent.

Variable annuities are not as liquid as other investments: Most variable annuities have surrender penalties for the first four to seven years of the contract. Surrender penalties apply to withdrawals in excess of ten percent of the account value. A ten percent federal excise tax is imposed for withdrawals before age 59-1/2.

Tax rate: Variable annuity gains are taxed at ordinary rates. Most long-term investment gains are taxed at the lower capital gains rate.

Gains taxed first: Distributions from variable annuities that aren't regular payments are taxed at ordinary income rates until there are no gains left in the contract. Loans from non-qualified annuities may be taxable.

Risk: Variable annuities also have risk like mutual funds and other investment products do.

Who Can Benefit from a Variable Annuity

  • If you have "maxed out" your contributions to your employer-sponsored retirement plan or your IRA, a non-qualified variable annuity may be a good option to supplement your retirement savings. There are no restrictions on contributions, and your investments grow tax deferred. 
  • Investors who are retired or close to it may benefit from the lifetime income options variable annuities offer. There are options for fixed income payments, income that rises and falls with investment performance, and provides income for the longer of two lifetimes. Variable annuity downside protection features may also be attractive to "pre-retirees."
  • Some investors who change their portfolio on a regular basis by using a rebalancing or other strategy may benefit from a low cost variable annuity. 

When You Should "Think Twice"

  • Unless you are looking for the protection features, there is no advantage to holding a variable annuity inside of an IRA or employer-sponsored retirement plan. There are no additional tax benefits.
  • You should think twice if you are not making the maximum contributions to your IRA or employer sponsored plan. 
  • Variable annuities are long-term investments. If you don't have other funds on hand for routine and other expenses, they're usually not a good choice.

What Should I Look for in a Variable Annuity?

Ratings: Financial strength of the insurance company is important. Review the ratings with your independent insurance agent.

Surrender charges: The surrender period is usually five to seven years. If it's longer, make sure you understand why. In any event, it shouldn't be longer than ten years.

Fees and expenses: Fees and expenses with optional riders can be over 3%. Make sure you know what you are buying and why. Be sure to look at several companies and compare the fees.


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Don’t Go It Alone

Variable annuities can be an important part of your retirement plan. While they have many features and benefits, they aren't for everyone. Talk to an independent insurance agent. They can help you decide if a variable annuity is right for you.

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The American College of Trust and Estate Counsel State Survey of Asset Protection Techniques

Advisor’s guide to annuities John Olsen

Insured retirement institute

SEC guide to variable annuities

Finra consumer guide

IRS Pub 575

IRS Pub 410

IRC 72