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What is a Variable Annuity?

Variable annuities are complex financial products that provide investors with a unique blend of insurance and investment opportunities. This article explores the nature of variable annuities, their potential benefits, risks, and cost considerations.

Variable Annuities: A Dual-Purpose Financial Vehicle

A variable annuity is a type of annuity contract where the value fluctuates based on the performance of an underlying portfolio of sub-accounts. Unlike fixed annuities that guarantee a specific return, variable annuities offer the possibility of higher returns, but also come with the risk of the account's value declining.

Essentially, variable annuities provide a way for investors to gain exposure to the market, with the potential upside and downside that accompanies such exposure. A significant feature of variable annuities is the offer of downside protection, albeit for a fee - the insurance guarantee. This unique combination makes variable annuities a particularly attractive option for investors seeking to balance risks and rewards.

Sub-Accounts and Riders: Key Components of Variable Annuities

Sub-accounts are integral to the structure of variable annuities. Conceptually identical to mutual funds, they lack ticker symbols for easy tracking, but they serve as the building blocks of your annuity investment. These sub-accounts function as institutional-level mirrors of retail mutual funds, providing market exposure.

Riders, or additional features that you can add to your annuity contract, contribute to the appeal of variable annuities. Each rider usually comes with a separate charge. Notable among them is the principal protection rider, which shields your investment from significant losses.

Costs and Potential Drawbacks

While variable annuities offer the potential for growth and income, they come with certain costs. Fees and charges are built into variable annuities, and these costs cover agent commissions, management fees, and other operational expenses.

One such cost is the surrender charge, a fee levied if you decide to withdraw a substantial amount from your annuity within a specified period. However, most annuities provide a 10% withdrawal window free from surrender charges.

Tax Considerations

Variable annuities enjoy tax-deferred growth, meaning you don't pay taxes on earnings until you withdraw them. But the tax treatment of withdrawals might not be so appealing. For non-qualified money, variable annuities follow a "last-in, first-out" policy. This means gains are the first to be withdrawn and are taxable as income rather than capital gains. Despite this, if investors have maxed out their other tax-advantaged investment options, the tax-deferral feature of variable annuities might still make them an attractive option.

Types of Variable Annuities: Deferred and Immediate

The most popular type of variable annuity is the deferred annuity. Frequently used for retirement planning, it promises a regular income stream, beginning at a future date. Immediate annuities, however, start paying income immediately after purchase.

Variable annuities are a unique financial product offering a blend of investment and insurance features. They can be a valuable tool in retirement planning, but their costs and tax implications must be carefully considered. Always consult with a financial advisor to ensure a variable annuity aligns with your overall investment strategy.


Variable annuities generally provide investors with downside protection for a fee (the insurance guarantee), while also providing market exposure that may give the investor upside potential.

A variable annuity is characterized by offering market exposure, and the risk and upside potential that comes with it, in the form of “separate accounts” which are institutional-level mirrors of retail mutual funds. Typically a variable annuity will not deplete the amount of your initial investment with sales charges, and may even credit your annuity with an initial bonus amount of several percent.

The charges and fees are built into it, however, and they make sure they can pay commissions to the agent who sold it to you by putting a surrender charge on the annuity to discourage your from closing the account for several years. With most annuities, you have a 10% withdrawal window that is free from surrender charges.

You can reallocate and rebalance your investments in your variable annuity over the years in an attempt to manage an investment strategy. If the account value tanks, you can lose your invested amount. There is such thing as principal protection riders to the annuity contract, however.

The riders are part of what make annuities a useful vehicle, but they all usually come with their own separate charge. A variable annuity might have a death benefit reset rider that will allow you to increase the amount that would go to your beneficiaries if the account value tanked.

They will all come with some form of income option, with which you can turn your variable annuity into a fixed income annuity. Some riders may let you turn portions of your accumulation value, as it’s called, into income.

Variable annuities grow tax-deferred, but, the tax treatment may not be so nice on withdrawals. On non-qualified money, variable annuities and have a last-in first-out policy, meaning the gains, which are the last things to go into the account, must the the first to come out of it, and therefore the entire withdrawal will be taxable, and not as capital gains, but as income.

This may still be the most advantageous place to grow money for some people, given the tax-deferral, if they have maxed-out their IRAs and other tax-advantaged vehicles.

How Should My Strategy Change With Age?
What are Tax Benefits of Annuities?
What are the Different Types of Annuities?

 Disclaimers and Limitations

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