What Are the Pros and Cons of a Variable Annuity?

A variable annuity is a retirement account. The account owner can use the funds to provide a regular monthly income, subject to the fluctuations in the value of the investments chosen for the account.

The value of a variable annuity depends on the owner’s tax situation, investment and retirement objectives, and time horizon. Talking with a licensed financial professional can help determine whether a contract is right for you.

What Is a Variable Annuity?

A variable annuity is issued as a contract placed inside an Individual Retirement Account (IRA) or another retirement plan that grows on a tax-deferred basis:

• The account owner chooses which group of mutual fund subaccounts the premiums are invested in.

• Most contracts include living and death benefit riders that guarantee a minimum account value or a stream of income.

• Because the value of the funds fluctuates with the markets, the principal is not guaranteed.

• A 10% early withdrawal penalty applies to distributions taken before the contract owner turns 59 ½, with certain exceptions for death, disability, or other factors.

What Are the Advantages of a Variable Annuity?

A variable annuity offers the following advantages:

Unlimited Contributions

Although most carriers limit the initial purchase, there is no limit to the amount that can be invested in a variable annuity. Therefore, variable annuities are popular tax shelters for wealthy investors.

High Guaranteed Rates

Many variable annuities pay an instant bonus on money invested in the contract. Others offer a dollar-cost averaging program that pays a high fixed rate on the initial balance and moves funds into your preselected subaccounts over a set period, such as 6 or 12 months.

Potential for Superior Returns

Investing in stock subaccounts and holding the funds for at least 20 years can result in a higher return on investment (ROI) than other annuity types:

• Most variable annuities offer periodic rebalancing and other basic money management services.

• Selling some overperforming assets and buying underperforming ones to bring your asset allocation back to its original target mix helps manage risk, maintain your investment strategy, and ensure your portfolio aligns with your goals over time. 

• The fixed accounts available in variable contracts offer higher rates than comparable fixed products.

Tax Deferral

A variable annuity grows tax-deferred. The distributions are taxable in the year made.

Insurance Protection

Most variable annuities offer living and death benefit riders that provide a minimum account value or a guaranteed income stream:

• The living benefit rider pays a guaranteed income stream based on a hypothetical guaranteed growth rate from the subaccounts. The contract owner receives the payout even if the subaccounts fall short of the growth rate.

• The death benefit rider guarantees the beneficiary the largest of three factors: the current contract value, its highest value on the date of the contract anniversary, or a value based on a guaranteed hypothetical growth rate.

Protection from Creditors

Many states mandate that creditors cannot attach money invested in variable annuities, protecting contract owners if they default on debt.

Avoidance of Probate

Because variable annuities are unconditionally exempt from probate, beneficiaries can quickly access their money.

What Are the Disadvantages of a Variable Annuity?

A variable annuity comes with the following disadvantages:

High Fees 

A variable annuity comes with many fees, including mortality and expenses fees, mutual fund subaccount management fees, contract maintenance fees, and other miscellaneous expenses:

• Most contracts include a substantial back-end surrender charge schedule that might not expire for 10 years or longer.

• Living and death benefit riders subtract periodic fees from the contract balance.

• Some contracts charge transaction fees after a specific number of transactions.

Poor Tax Treatment

A variable annuity has the same 10% early withdrawal penalty as traditional IRAs and qualified plans. All distributions are taxed as ordinary income unless the contract was placed inside a Roth IRA.

Poor Cost Basis

Unlike with stocks and other securities, the cost basis of variable annuities does not step up upon inheritance. Beneficiaries pay tax on the contract value, which has increased from the purchase date.

*This information is for educational purposes only.

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