If you want the potential for income growth in retirement, a variable annuity is a simple and effective solution. With guaranteed income and riders that protect your family, variable annuities combine the benefits of life insurance, a fixed annuity, and investing in the market.
What is a variable annuity?
A variable annuity is a contract with an insurance company. You pay an initial investment in exchange for monthly payouts from the insurer. This monthly income is variable based on the performance of the investments you choose.
When you purchase a variable annuity, you choose from a selection of investments. The money used to purchase the annuity, also called the principal, is then invested in these subaccounts that you choose.
Basically, you trade your principal investment for accumulation units that you use to invest in the market.
You can use these units to invest in a number of subaccounts. These consist of a variety of assets including stocks, bonds, and money market funds. In most cases, you’ll choose from a pre-selected list of funds that are approved by professional investors in your insurance company. This mitigates some of the risk of investing without in-depth knowledge of the market.
This investment portion of a variable annuity is what makes it different from a fixed annuity. With a fixed annuity, the insurance company invests your funds for you and provides a guaranteed, consistent return each month. With a variable annuity, you choose how the money will be invested.
A fixed annuity offers a predetermined, set amount of income per month. This does not increase or decrease depending on external factors. A variable annuity can cause different payouts each month depending on the performance of the investments you choose.
A variable annuity combines the characteristics of a fixed annuity with the benefits of participating in the market.
How are variable annuities taxed?
In a variable annuity, your gains or interest is accumulated on a tax-deferred basis. This means that you don’t pay taxes on those gains until you begin withdrawing payments (called the point of annuitization). This helps grow your account at a faster rate than taxing on an annual basis.
The tax-deferral is an especially useful feature for investors who are in high tax brackets now but anticipate that they’ll be in a lower tax bracket in retirement. This means your money will grow at a greater rate now, but it will be taxed at a lower income rate in the future.
What are the types of variable annuities?
There are two types of variable annuities: deferred and immediate.
The insurance company will start paying you out right after purchasing an immediate variable annuity. You’ll pay a lump-sum deposit, and the variable annuity will start paying out next month. Typically, the monthly payout of an immediate annuity is based more on life expectancy and less on your investment portfolio.
With a deferred variable annuity, you invest a lump sum of money that collects interest over a set period. This interest is tax-deferred until you start taking payments. Your chosen subaccounts will collect money, which will then turn into the monthly payouts you’ll receive at the point of annuitization. Deferred annuities help grow your savings until you start withdrawing payouts.
Will a variable annuity protect my family?
The insurance company will typically keep your principal. Once you start taking payments, the terms are locked in. Your family or beneficiaries would not receive the principal back, even if you died two months after starting payouts.
You can offset this risk with a guaranteed death benefit. This qualifies your annuity as an insurance contract, so your designated beneficiary will get back the original amount you invested if you die before taking enough payments to equal your principal. This ensures your beneficiaries receive no less than your initial investment.
You’ll usually have to pay a mortality charge for a guaranteed death benefit.
What are the advantages of a variable annuity?
Because your income payments are based on the performance of your investment subaccounts, you have the potential to generate higher rates of return.
Fixed annuities will remain the same every month for the entire term limit. Variable annuities, though, let you pump up your savings for greater potential growth.
Because you can grow your savings, you can keep up with inflation changes.
A fixed annuity does not take inflation into account. Even if the market increases or drops, you would make the same.
Your investment in the variable annuity, however, would likely match the changes in the market to match and outpace inflation.
The gains from your variable annuity are tax-deferred. This means you don’t start paying income tax until you begin withdrawing funds. This pumps up your savings towards greater gains in the long-term.
Once you annuitize your contract, the insurance company guarantees a certain payout for the rest of your life. The income will be variable, but most companies will offer a feature where you are guaranteed a minimum payout each month regardless of the market’s success.
In some states, annuities will shelter against creditors and lawsuits. This can protect your assets (like your annuities), especially if you work in a hazardous occupation or have liability concerns.
In a variable annuity, you have the option to select which subaccounts in which you want to invest. It’s easy to change your portfolio at any time. This gives you greater flexibility and control of your investments.
What are the disadvantages of a variable annuity?
Your income will be dependent upon the value of your investment portfolio. While this can mean greater gains, it can also mean some months provide significantly lower income. With a variable annuity, you should be risk-averse and able to plan your retirement funds well.
Most insurance companies will offer a minimum payout rider, so you can agree to a set minimum amount that you’ll receive monthly even if the market crashes. This ensures your security in retirement despite the economy.
If you’re not sure of your investment risk tolerance, talk to a Sunpath agent today.
For some people, tax-deferral might actually not be the best option.
For example, investors with a large portfolio might find that they face higher tax rates if they wait to take their capital gains in the future. Income tax is dependent upon how much that income is worth at the time—regardless of the rest of your lifestyle or previous salary.
If you anticipate your annuity will create a higher income, you might not want taxes to be deferred to a later time period with higher tax bracket.
Once you annuitize and begin receiving payments, your decision is final. The money is locked into that annuity account. If you choose to withdraw for cash or to roll into another annuity, you’re usually subject to high fees.
You also can’t touch your funds until the age of 59 and a half or the IRS will collect 10% of the funds.
Fees and charges
Variable annuities have a number of fees that you’ll have to pay, and they can often be pretty expensive.
Most insurance companies charge a surrender fee, which usually starts at 8-10% the first year and decreases each year by 1-2% until maturity.
For example, you have a $100,000 investment and your surrender fees start at 10%. If you withdraw your money from the annuity in the second year (at 9% surrender charge), you would have to pay the company $9,000 in surrender fees.
You may also be charged annual fees and administrative costs, which are typically between 1.4% and 2.5%. You may also have to pay commission for your agent as well as investment fees for your subaccounts.
You should discuss this with an agent, as a number of fees are hidden deep within your annuity contract.
Is a variable annuity right for me?
If you’ve maxed out your contribution to your 401(k)s and IRAs, a variable annuity is the next logical solution. But it’s also a great option for anyone interested in safely participating in the market.
A variable annuity provides a variable income stream. While this can be risky if the market fails, it can also show high returns if properly invested. This can help outpace inflation and provide greater tax-deferred gains over time.
A variable annuity is a long-term investment that will direct the amount of your monthly income stream. This makes it best for those who are risk-averse and who understand the ups and downs of the market.
But you can mitigate some of this risk with guaranteed death rider benefits and minimum payout riders.
Not sure if it’s right for you? Alternatives to the variable annuity include index funds, tax-managed funds, and fixed annuities.
Contact a Sunpath Financial advisor now to start searching for the right type of annuity and plan for your lifestyle.