A variable annuity can be an efficient way to help grow funds that you plan to turn into income in retirement.
Variable annuities mix investments with insurance to provide you the option of a predictable payout when you retire.
Because variable annuities come in many shapes and sizes, you may want to consult with a financial advisor to determine if they would work as part of your retirement plan.
When you’re saving for retirement, you have a number of options. You’re probably familiar with traditional investments. Another way you can accumulate funds for retirement is with an annuity. Many people who use an annuity to save for retirement choose a type known as a variable annuity. A variable annuity can be an efficient way to help grow funds that you plan to turn into income in retirement. But how do variable annuities work?
Variable annuities are part investment, part insurance—meaning they offer a combination of tax-deferred growth potential and set you up to take advantage of the guaranteed income an annuity can provide in retirement.1 The “variable” in variable annuities comes from the fact that the return they provide as you’re accumulating funds for retirement can go up and down depending on the performance of investment options—sometimes called subaccounts—you select.
How do variable annuities work?
Variable annuities are used to accumulate funds for retirement. Then when you get to retirement, you have flexibility to withdraw your funds all at once, over time or to convert them into an income plan to generate retirement income that you can’t outlive. Here’s how it works:
The accumulation phase begins when you contribute to a variable annuity. The money you contribute is invested in one (or more) portfolios—also known as subaccounts—offered by your insurance company. You decide how to allocate your money among the different portfolios, which may include pre-packaged funds based on your risk tolerance or other factors. Ultimately, the subaccounts performance, like other investments, is tied to the performance of the greater market or other underlying investments.2 Once your money is invested, earnings grow tax deferred until you withdraw them, usually in retirement. The earnings are then taxable as ordinary income when they’re distributed.
When you get to retirement, you will have several options for the value in your contract. These include:
- Converting to an income plan that will provide regular monthly income that’s guaranteed to last the rest of your life. You can also choose a minimum amount of time the annuity will pay out, say 10 or 20 years. If you pass away during that time, the payments will go to your beneficiary.
- Converting to an income plan that will pay you regular monthly income that is guaranteed to last for the rest of your life and your spouse’s, no matter how long you live. This is known as a joint and survivor option. You can also guarantee these payments will last for a minimum amount of time.
- Taking a lump-sum payment.
- Taking systematic withdrawals.
If you decide to convert to an income plan, you will likely have several options, including:
- A plan with fixed payments that won’t change based on what happens in the markets.
- A plan with variable payments that will go up and down with market performance.
A portfolio plan where payments are tied to the insurance company’s general account and can increase over time with dividends3 .
How do guaranteed living benefits of variable annuities work?
Some variable annuities offer something known as guaranteed living benefits. These typically include minimum income benefits or benefits that protect the principal of your investment no matter how the market performs. While these can provide value, they also tend to add significant cost to the annuity.4
If you don’t need these guarantees, you can find variable annuities that don’t offer them, which tends to make the annuity more cost effective.
Early annuity withdrawals: surrender charges and fees
Variable annuities allow you to take money out whenever you want prior to the income phase; however, to do that, you may have to pay a surrender charge in addition to taxes. Generally, surrender charges decline over time; eventually, no surrender charge applies. If you begin taking withdrawals prior to age 59 ½, you may also owe taxes and a 10 percent IRS penalty.
Is a variable annuity right for you?
The ability to combine growth potential with guaranteed lifetime income can make variable annuities an attractive choice, especially if you’re looking for a simple, all-in-one solution for retirement planning.
In particular, variable annuities can make sense if you want to:
- Sock away additional funds for retirement above and beyond what you’re permitted to contribute to your 401(k), IRA and other tax-deferred retirement plans you may have.
- Create a guaranteed income to help meet daily expenses in retirement.
- Roll over a retirement account from a previous employer into something that can grow in a tax-advantaged way and be converted into guaranteed income in retirement.
Because variable annuities come in all shapes and sizes, it’s important to work with a company you trust. Speak with a financial advisor who can help you compare variable annuities and assess whether their features, guarantees and options, costs and other factors work for you.
How to exchange your variable annuity
If, for any reason, you want to exchange your nonqualified variable annuity, for a different insurance product you may be able to do so—without incurring an immediate tax on any investment gains associated with the original contract. Under Section 1035 of the Internal Revenue Code, you can legally swap a life insurance policy, annuity or long-term care product via a 1035 exchange. Specifically for nonqualified variable annuities, this means you can change to another type of nonqualified annuity or long-term care. There are tax-specific rules and not all exchanges qualify, so working with a financial advisor and your tax advisor is important to ensure you qualify for this preferential tax treatment.
Alternatives to variable annuities
Of course, annuities are just one part of a comprehensive retirement plan. Other sources that can provide you with income streams in retirement include:
- Social Security
- Investments (such as brokerage accounts)
- Qualified plans (such as 401(k)s and 403(b)s) and traditional or Roth IRAs
- Permanent life insurance
- Cash reserves
Ultimately, the goal of having different financial options is to give you flexibility in retirement.