How Does a Variable Annuity Work?

(Everything you need to know...and maybe a little more)

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.

Reviewed by Neel Lane
Reviewed by Neel Lane

Neel Lane is an independent contract paralegal who specializes in Medicaid and VA benefits. He helps people access and maximize the benefits that they're entitled to. He has over 30 years of experience in this area.

How does a variable annuity work

Running out of money  is a top concern in retirement, according to the Personal Financial Planning Trends Survey by the American Institute of CPAs. If you search the Internet for "retirement planning," Google comes back with 359 million results. That's a whole lot of information, but it all boils down to this. Retirement planning is about building wealth to create income. 

Variable annuities are a financial tool designed exactly for that. Building wealth and creating lifetime retirement income. 

So you want to know about variable annuities? Here’s everything you ever wanted to know, and maybe a little more. 

To use a matching tool that will find you the best insurance solution in your area, click here: independent agent. Provide a few details about what you need, and the tool will recommend the best agents for you.  Any information you provide will only be sent to the agent you choose.

What Is a Variable Annuity?

Variable annuities are policies issued by insurance companies. They pay a regular income for life or for a period of years. You buy a variable annuity policy by making a single payment or a series of payments. Variable annuities are deferred or immediate.

Variable annuities are qualified or non-qualified.

  • 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 variable annuities are personally owned and paid for with after-tax dollars.

How Variable Annuities Work: The Contract

A variable  annuity policy is a contract between the insurance company, the owner, the annuitant, and the beneficiaries. 

The owner of the policy has the sole right to the values and payments in the contract. The owner decides who both the annuitant and the beneficiaries are. The age and sex of the annuitant is how the insurance company determines how much and when income is paid.

 The annuitant and owner don't have to be the same person. When the owner passes away, the beneficiary receives the proceeds and can create their own schedule of payments at that time.

The insurance company issues the policy and has to honor the promises in it. The policy provisions detail all of the benefits and conditions, and the fees, charges and expenses. 


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Why It's Called a Variable Annuity

The value of variable annuities is represented by units. The value of each unit rises and falls with the investment it represents. The account value of a variable annuity rises and falls based on the value of the units, not because there are more or fewer units.

On the other hand, the value of fixed annuities is measured by dollars. When the value of a fixed annuity rises or falls it's because there are more or fewer dollars in the account.

Where Your Money Goes

When you contribute to a variable annuity, you choose from a selection of subaccount funds that are similar to mutual funds, and how much money is invested in each. The subaccount funds are part of the variable annuity separate account.

The variable annuity separate account is the foundation of a variable annuity. The insurance company offers, distributes, and sells a variable annuity through a separate account. It's called separate because it's not part of the insurance company's general account. The separate account is regulated as an investment company by the U.S. Securities and Exchange Commission (SEC), just like mutual funds are. Here's why a separate account is important to you.

The general account of an insurance company is largely a portfolio of corporate and government bonds. The money from fixed annuities and other products are invested in the general account. If the insurance company goes bankrupt, the general account is subject to the claims of creditors. That can be bad news for policyholders.

The separate account is not subject to the claims of creditors if the insurance company goes bankrupt. So, while the value of your retirement money in a variable annuity rises and falls with your investment selections, it is protected from a failure of the insurance company.

The Variable Annuity Prospectus

Building Wealth: How Your Money Grows in a Variable Annuity

Variable annuities are a way for investors to take advantage of professional money management and diversification. Variable annuities usually have a wide selection of investment options to choose from. Stock funds, bond funds, real estate, and other asset classes are often on the menu. Of course, mutual funds offer these options as well, so why are variable annuities different?

Variable annuities are tax-deferred investment vehicles. There is no tax on capital gains and dividends until money is distributed. For investors who regularly rebalance their portfolios between asset classes, tax deferral is important. That's because there is no tax when one investment is sold and another purchased.

Creating Retirement Income: Variable Annuity Options

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.

Variable annuities also offer fixed payment lifetime incomes through living benefit riders or lifetime annuity options. 

How Variable Annuities Work: Optional Features

Variable annuities come with a number of extra options for an additional charge that offer some market protection, like:

  • Guaranteed minimum income benefits (GMIB) provide a minimum amount of lifetime income regardless of what the account value is. The minimum income is based on the greater of the original investment accumulated at an interest rate specified in the policy and the actual account value.  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 policyholders retire, regardless of the account value. Unlike the GMIB, the owner does have access to the account values. Withdrawing money beyond the guarantee will reduce or eliminate the minimum income.
  • Guaranteed minimum accumulation benefits (GMAB) 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.
  • Lock-ins and step-ups.  Living benefit riders recalculate the basis for minimum income at least once a year. If the account value is greater than the current minimum, the account value is used as the new minimum and accumulated. This process is called a step-up, or locking in gains.

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Variable Annuity Death Benefits

Variable annuities also offer enhanced death benefits to protect beneficiaries from down markets. The standard death benefit of a variable annuity is the greater of the account value or the purchase payment. Riders offer options for more generous death benefits, like using the highest account value instead of the account value at death. 

Withdrawals reduce the death benefit, either dollar for dollar or as a proportion. A variable annuity proportional death benefit is reduced by the percentage withdrawn from the account value instead of the dollar amount.

Creditor Protection

Some types of assets can be protected from lawsuit judgments or bankruptcies. For some people who may be more likely to be sued (think doctors, corporate executives, etc.), protecting their assets from creditors can be a very important reason to get an annuity.  

Most states offer annuities some form of creditor protection. Some states protect all of the annuity proceeds from creditors , while others just protect the beneficiaries' interests. 

How Much Does a Variable Annuity Cost?

Variable annuities come with their own set of fees and expenses that can be anywhere from 1.2% to over 4% depending on the options selected. Some insurance companies, though, offer a “no frills” variable annuity for as low .75%. Among the fees and expenses you can expect to see are:

  • Front-end sales loads:  These are deducted from your purchase payment. 
  • Mortality and expense fees: These are asset-based charges for guaranteed death benefit and income options, typically between .2% and .35% .
  • Investment management fee: This is and asset-based charge for professional portfolio management, typically between .25% and 2%.
  • Administrative fee: This is a flat amount charged for annuity 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: Optional riders like income and death benefit riders have additional fees.

Structured Variable Annuities

Structured, buffered, or indexed variable annuities offer investors downside protection. You can choose from a selection of financial indices like the S&P 500, MSCI, and Russell 3000. Each selection offers a “downside” and an “upside.” The downside is how far down your account can go without loss. 

A 10% downside means the insurance company covers losses in your account up to 10%. The upside is the limit on how far up your account can go. A 10% cap upside means your account can only grow a maximum of 10% in a year regardless of how well the index performs. The insurance company keeps the balance.

Guaranteed Variable Annuities

Variable annuities are investments that are not guaranteed by the insurance company or a federal agency. There are, however, optional features within variable annuities that offer guarantees. Living benefit options offer guaranteed minimum income regardless of investment performance. 

Death benefit options can guarantee that beneficiaries will receive a minimum value regardless of investment performance. All guarantees are made by the insurance company and depend on its ability to pay claims.

How Is a Variable Annuity Taxed?

The big picture is, if you didn't pay taxes on the money going in, you pay taxes on the money coming out. Variable annuities aren't eligible for the lower capital gains rate. They're taxed as ordinary income. Any money that you take out before age 59-1/2 will generally result in a 10% penalty tax.

Withdrawals or loans from a non-qualified variable annuity are taxed as gain first. That means that the money is fully taxable until all of the growth in the account is taken out. Income from an annuity option is partially taxable. 

The amount of the annuity payment that is considered principal is excluded from taxable income. Surrenders are taxed based on the surrender value minus total purchase payments. 

All money received from a qualified variable annuity is 100% taxable at ordinary income tax rates. 

The chart below summarizes the tax treatment of variable annuities.

Non-qualified Qualified Qualified/Roth 
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 purchases and loans repaid within five years. IRA loans not permitted. Pension plans may have exceptions for home purchases and loans repaid within five years.
Death benefits Gain is taxed at ordinary rates. Proceeds will be taxed as "gain first." 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  the end of the fifth year.

What's Next?

Variable annuities are flexible financial tools, but they're not for everyone.  Independent insurance agents are annuity professionals. They can help you decide if one is right for you.

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