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A variable annuity is an agreement between you and an insurance company. It functions as an investment account that can grow tax-deferred and contains some insurance benefits, such as the possibility to convert your account into a stream of periodic payments. A variable annuity contract can be purchased with one or more purchase installments.

A variable annuity provides a variety of investment alternatives. The value of your contract will fluctuate according to the performance of the investment alternatives you select. A variable annuity’s investment options often include mutual funds that invest in equities, bonds, money market instruments, or a combination of the three.

First, variable annuities have insurance features. For instance, if you die before the insurance company starts making income payments to you, many contracts guarantee that your beneficiary will receive at least a specified amount. This is typically at least the amount of your purchase payments. It may also offer additional insurance features such as promising you a certain account value or the ability to make withdrawals up to a certain amount each year for the rest of your life.

Second, variable annuities are tax-deferred. That means you pay no federal taxes on the income and investment gains from your annuity until you make a withdrawal, receive income payments, or a death benefit. You may also transfer your money from one investment option to another within a variable annuity without paying federal tax at the time of the transfer.

When you withdraw your money, however, you will pay tax on the gains at ordinary federal income tax rates rather than lower capital gains rates. Under certain circumstances, the death benefit may not be subject to federal estate tax. In general, the benefits of tax deferral may outweigh the costs of a variable annuity only if you hold it as a long-term investment.

Third, variable annuities let you receive periodic income payments for a specified period or the rest of your life (or the life of your spouse). This process of turning your investment into a stream of periodic income payments is known as annuitization. This feature offers protection against the possibility that you will outlive your assets.

Tax Rules

  • The federal tax rules that apply to variable annuities can be complicated. In addition, there may be state tax implications. Before investing, you may want to consult a tax adviser about the tax consequences of investing in a variable annuity.
  • Retirement plans, like IRAs and employer-sponsored 401(k) plans, may also provide you with tax-deferred growth and other tax advantages. For many investors, it will be best to max out their contributions to IRAs and 401(k) plans before investing in a variable annuity.
  • If you are investing in a variable annuity through a tax-advantaged retirement plan, you will get no additional tax advantage from the variable annuity.
  • There may be federal tax penalties if you withdraw your money before a certain age.

How a Nonqualified Variable Annuity Works

Nonqualified variable annuities are tax-deferred investments with a distinct tax structure. While you will not receive a tax deduction for your contributions, your account will grow tax-free until you take money out, either through withdrawals or as a regular income in retirement.

Variable annuities work similarly to the majority of insurance company-sold annuity contracts. In exchange for your investment, the insurer agrees to provide you a monthly stream of income, which typically begins at retirement age and continues for the remainder of your life.

A qualified annuity is a type of retirement account, much like a traditional individual retirement account (IRA), that typically entitles you to a tax deduction for the amount you contribute, up to Internal Revenue Service (IRS) limits. A nonqualified annuity, on the other hand, is not considered a retirement account for tax purposes and doesn’t earn you a deduction—even if you are using it to save for retirement.

You make contributions to a nonqualified variable annuity with after-tax dollars, like adding money to a bank account or any investment outside of a retirement plan. The insurer then invests your contributions in the subaccounts, which are similar to mutual funds, of your choosing. The value of the annuity will vary according to the performance of the investments you selected. With a fixed annuity, by contrast, the insurer picks the investments and promises you a predetermined return.

Although you don’t receive any upfront tax break with a nonqualified annuity, the earnings on your subaccounts grow tax-deferred. That is the unique tax advantage of these annuities. With other nonqualified accounts—such as a brokerage account or mutual fund—the interest, dividends, and capital gains distributions your investments generate are taxed for the year in which you receive them. That’s true whether you take the money in cash or simply reinvest it.

The earnings in your variable annuity account become taxable only when you withdraw money or receive income from the insurer in the payout phase of the annuity. At that point, the money you receive is taxed at the same rate as your ordinary income.

Tax on Withdrawals and Income

When you receive money from a nonqualified variable annuity, only your net gain—the earnings on your investment—is taxable. The money you contributed to the annuity isn’t taxed because you made it with after-tax dollars. As a result, a portion of each payment you receive is treated as principal (that is, a return of your investment in the contract) for tax purposes.

How is this calculated? Essentially, the nontaxable portion of each payment is determined by the ratio of your investment in the contract to the account balance. More precisely, the tax-free and taxable portions of annuity payments are figured using a special computation explained in IRS Publication 575.

The insurance company will report the total annual payouts to you and to the IRS on Form 1099-R. Usually, the form will also show your taxable amount, so that you won’t have to figure it out yourself.

Variable annuities entail considerable costs in the form of an insurance fee, which covers any guaranteed death benefit, as well as an administrative fee. These fees are based on a percentage of the value in the contract and apply every year. They can average about 1.5% or more annually, depending on the insurance company and other factors. You cannot deduct these amounts as investment expenses. They become part of your cost (investment) in the contract.

High-income taxpayers must include the taxable portion of their variable annuity income in calculating their 3.8% additional net investment income tax.

What is a Key Advantage to Living Benefit Variable Annuities?

A variable annuity is a long-term investment package provided by an insurance company that is intended to help you save for retirement. You put your money in professionally managed portfolios, which are similar in some ways to mutual funds. Your money grows tax-free until you start receiving income at a later date. When you buy an annuity, you may also receive a standard death benefit, which can help you leave a legacy for your family.

Read Also: The Impact of Market Volatility on Variable Annuities

Unlike many other financial instruments, variable annuities combine the benefits of investing (choice, flexibility, and tax deferral) with insurance (income guarantees and legacy protection) in a single retirement plan.

Let’s take a look at each advantage offered by a variable annuity.

Advantage #1: Choice and Flexibility

When it comes to investing, one thing just about everyone can agree on is the importance of diversification to help avoid the risk of losing money. Most variable annuities offer a range of investment options across a variety of asset classes, strategies, styles and sectors. Spreading your money among investments can help reduce your risk in down markets.

Variable annuities also allow you to transfer money among investment options without sales or withdrawal charges.

Advantage #2: Annuity Tax Benefits

With a variable annuity, any growth in your account is tax deferred until you begin taking withdrawals at a later date (when you may be in a lower tax bracket). Thus, all the money that would have been paid annually in taxes stays in the account with the opportunity to grow until it is withdrawn. You also have the added flexibility to rebalance or strategically move money within your investments without incurring annual taxes.

A variable annuity also offers you the flexibility to rebalance or strategically move money within your investments without having to pay year-end taxes.

It’s important to know that you can only take advantage of tax deferral if you buy your annuity with money from outside of “qualified” retirement accounts, such as 401(k)s, 403(b)s and IRAs (because these are tax-deferred already). Many people choose to do so anyway, because they want to take advantage of the annuity’s other features and benefits, including death benefit options, range of investments and guaranteed income payout options.

If you are considering purchasing an annuity with funds from a qualified account, it’s best to speak with your tax advisor.

Advantage #3: Income Guarantees

Annuities provide two ways to guarantee your retirement income:

  1. Annuitization:When you’re ready to start taking income, you can annuitize, which means you would turn over control of the money in the account to the insurance company in return for a regular stream of income payments in retirement.

    Those payments would continue either for life, for a specified period of time (often 10, 20 or 30 years), or for a combination of the two (eg. life with 10 years). When you pass away, the insurance company would fulfill any remaining payment obligations to your beneficiaries for the elected time period, and keep any remaining money.
  2. Optional Lifetime Income Guarantees:In addition to annuitization, today’s annuities offer living benefits, for an additional fee, that function in a similar way to annuitization, but with more flexibility. These benefits provide income guarantees – including lifetime income – that essentially insure your future income, without giving up total control of your money.

    When you purchase a variable annuity with an income guarantee, your future income level can be protected even if your account’s investments perform poorly. In addition, some living benefits offer guaranteed income growth as well as the opportunity to capture gains when the market goes up. Once you begin taking income you can withdraw up to a specific amount each year as a guaranteed income stream for life, subject to the limitations outlined in your contract.

    Typically, these optional lifetime income benefits are available for an additional fee, but also can be built into the annuity.

Advantage #4: Legacy Protection

Most annuities today offer a standard death benefit to help provide a legacy for your loved ones. It typically works like this: After the owner dies, the beneficiaries will receive at least what the owner has paid into the annuity, minus any withdrawals OR the current account value of the annuity, whichever is greater.

This death benefit is generally built into the variable annuity at no extra cost. Some annuities do offer enhanced death benefits for an additional fee.

What is the Greatest Risk in a Variable Annuity?

A variable annuity can offer you a tax-advantaged way to save for retirement and an additional stream of income. The value of your annuity will depend on the performance of your chosen investments and the terms that will govern how you receive payments or make withdrawals.

Variable annuities typically have two phases:

  • Accumulation phase: This is the initial phase when the policyholder makes contributions or investments into the annuity contract. During this phase, the invested funds have the opportunity to grow through a selection of investments. These often include mutual funds or other securities. The value of your annuity will fluctuate based on the performance of those investments. And the earnings within the annuity are generally tax-deferred, which means that taxes on the gains are postponed until you make withdrawals.
  • Annuitization or distribution phase: This phase begins when you, the policyholder, decides to start receiving payments from the annuity. This is typically done during retirement. There are various options for this phase, including annuitizing the contract to get a series of periodic payments. These payments can be fixed, variable, or a combination of both. Alternatively, you can make withdrawals or take lump-sum distributions.

Take note: The distribution method that you will pick can affect the how much and when you will get income during retirement.

Additionally, you should keep in mind that variable annuities can offer optional features or riders that provide added benefits for an additional fee. These can include death benefits, which guarantee your beneficiaries a minimum amount upon your passing. These features can add a layer of security, but will also increase the overall cost of the variable annuity.

Risks of a Variable Annuity

Before you buy a variable annuity, you should carefully consider the risks against the benefits. Here are five common risks that could affect your investment:

  • Market risk: Variable annuities are subject to market fluctuations, and the value can go up or down based on the performance of the underlying investments, potentially even resulting in a loss of principal.
  • High fees: Variable annuities can come with various fees, including mortality and expense charges, administrative fees and investment management fees, which can significantly reduce your overall returns over time.
  • Surrender charges: Many variable annuities have surrender charges that penalize policyholders for withdrawing funds before a specified holding period, limiting liquidity and making it expensive to access your money in the short term.
  • Tax consequences: While variable annuities offer tax-deferred growth, withdrawals may be subject to ordinary income tax. And if you take money out before age 59½, you may also incur a 10% IRS penalty, which will reduce your tax advantages.
  • Complexity: The wide range of investment options, riders and contract features associated with variable annuities can make them complex and difficult to understand. And as a result, misinformed decisions could have a negative impact on your investments.

Who Bears All Risk in a Variable Annuity?

As the policyholder, you will bear the majority of the risk associated with a variable annuity. Because the performance of the underlying investments in your annuity is directly tied to financial markets, any gains or losses will get passed on you.

During the accumulation phase, when your annuity gets funded, you will choose from a range of investment options that often include mutual funds or other similar investments. The returns on these are not guaranteed and can fluctuate with market conditions, therefore passing on the market risk to you.

Additionally, you may also be at risk of outliving your savings during the distribution phase, if you choose to annuitize the variable annuity. The periodic payments received during retirement are based on the performance of the investments that you selected, and if the investments perform poorly, the policyholder may receive less income than expected. This risk, however, can be mitigated to some extent by selecting optional living benefit riders that provide income guarantees. But as noted earlier, these typically come at an additional cost.

You should also be aware that while policyholders bear the investment risk in a variable annuity, insurance companies offering these products do provide some level of protection against certain risks. For example, you may have optional features for death benefits or living benefit riders. But these often come with additional fees.

Final Words

A variable annuity can be an excellent retirement investment if you want to combine tax-deferred growth with investment flexibility. However, you should be aware of the dangers that could reduce the value of your investments, as well as the conditions of your annuity, which may include fees and penalties.

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