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Is a Variable Annuity a Good Idea?


Variable annuities offer strong growth potential and considerable risk all at once. Because the returns you earn through a variable annuity are based on the performance of an investment portfolio, you stand the chance of losing money. However, there are a few limitations on how much you can earn with a variable annuity, which makes them undoubtedly enticing. Whether a variable annuity is a good idea for you is a deeply personal decision, as it completely depends on your needs. If you have specific questions about annuities or retirement planning, it can be helpful to reach out to a financial advisor.

How Does a Variable Annuity Work?

A variable annuity starts with making payments to an insurance company and choosing funds to invest money in. By purchasing an annuity, you’re taking on an insurance contract that provides income for retirement based on how your investments perform.

All annuities have two components: the principal you pay into it and the returns on that principal. Generally, you pay a lump-sum premium into the policy or you pay over a period of time. Variable annuities are deferred, as buyers typically wait years to begin taking payments.

The “variable” in a variable annuity refers to its potential returns and investment selection. You invest the funds in your variable annuity in one or more funds, most of which are mutual funds that focus on specific areas of the market. Because of the volatility any investment can experience, the value of your account can rise and fall with the market. You may lose money, but you might also earn quite a bit. This is in contrast to a fixed annuity, which operates like a certificate of deposit and earns a set interest rate.

Once you retire, you can turn your principal and earnings into a stream of income for a set period of time or for life. If you die before you annuitize (receive all the payments of your annuity), the insurance company will typically guarantee a death benefit payment to your beneficiaries of at least what you put in, minus any withdrawals and taxes. In exchange for all these benefits, however, there are steep fees and costs.

Variable Annuity Costs

More specifically, variable annuities have the most extensive fee structure of any annuity type. They often feature some combination of contract fees, investment fees, mortality and expense risk fees, and more.

Total fees can have a significant impact on your returns, ranging from 2% to 3% and higher. So, if you have a $100,000 variable annuity with an annual fee of 3%, you would pay $3,000 in fees each year. And if your annuity returns 5.55% in a given year, you would only see a net return of 2.55%, or $2,550 after fees.

These charges can add up over time, which only takes away from your potential growth. However, what you’re betting on with a variable annuity is that you’ll be able to outperform those extra costs so you still come out ahead.

To protect against losses, an insurance company will offer guarantees for an additional cost. For example, you could pay extra for a rider that will lock in earnings for 10 years so they will be part of the calculation when you annuitize. These riders allow you to customize your contract so it better fits your plan.

Benefits of Variable Annuities

There are many pros and cons to annuities and, more specifically, variable annuities. The biggest benefit of a variable annuity is the potential growth your money could earn. Compared to many other types of annuities, such as fixed annuities, a variable annuity potentially offers the best possible return. This is because your money is in the markets. Here are the other major benefits:

  • Money grows tax-deferred: Another benefit, which is true for all annuities, is that your money grows tax-deferred. So the money you would have paid to the IRS stays in your account and can continue to grow.  You won’t owe income taxes until you make a withdrawal or start receiving payments from your variable annuity.
  • Lifetime income: Additionally, as with all annuities, a variable annuity offers a protected lifetime stream of income. For many, the knowledge that they won’t outlive their money gives them great peace of mind. If you live longer than the actuaries predict and your account is empty, the insurance company will still send you regular payments for as long as you live.
  • Protected funds: The money in an annuity is protected from any creditors you may have since the insurance company actually has the money. This makes an annuity one of the safest investments available.

Drawbacks of a Variable Annuity

A woman deciding if a variable annuity is a good idea for her retirement plan.

Before you rush out to buy a variable annuity, you should be aware of the drawbacks of this retirement savings vehicle. Here are the most important things to be aware of that might be a negative for your situation:

  • Overall cost: A variable annuity’s biggest disadvantage is its cost. Variable annuities can charge high fees. These include administrative fees, fees for special features and fund expenses for the mutual funds you invest in. And then there are the sales commissions.
  • Risk fees: Also, there’s the mortality and expense (M&E) risk charge. This charge, generally around 1.25% of your account value, is charged annually as compensation to the insurance company for taking on the risk of insuring your money. When you add up these fees and charges, variable annuities can be a pricey place to store your money.
  • Low return potential: A variable annuity may provide a lower return than the other kinds of annuities. It all depends on the markets. If they’re down, so is your money.
  • Lack of access: If you have yet to reach retirement, variable annuities, or all annuities for that matter, are virtually inaccessible. This is because of the surrender charges that insurance companies institute in these contracts. That means any withdrawals made during that time that are above the amount you’re allotted will incur an extra charge, sometimes up to 10%.

Variable Annuity vs. Fixed Annuity

While a variable annuity earns returns through investment performance, a fixed annuity grows via a specific interest rate that the insurance company presets. The market can also dictate the quality of these fixed rates.

As you might expect, a standard interest rate likely won’t ever outperform investments. That’s because mutual funds and other securities have exponential growth opportunities, whereas the fixed rate market is considerably more stagnant. In good market conditions, a fixed annuity’s interest rate might hover around 3%. However, in 2024, interest rates ranged from 4% to 5%, and sometimes more.

If you’re wondering why investors would get a fixed annuity, it boils down to risk and fees. There’s minimal volatility in the fixed rate market, which can be enticing, especially for those close to retirement who already have a sizable pool of savings. In addition, while variable annuities charge a multitude of fees, fixed annuities often have no annual fees whatsoever. On occasion, an insurance company might allow you to buy an extra rider, though.

In the end, variable and fixed annuities are versions of the same thing, so they share many of the same benefits. Tax-deferred growth is perhaps the most important among these similarities. In fact, they both allow your funds to grow without incurring income taxes. Then, once you retire, you’ll pay income taxes on your withdrawals.

Beyond that, death benefits are available for both fixed and variable annuities during the accumulation phase of a contract. Therefore the contract owner’s assets are protected in both cases should they pass away earlier than expected.

Is a Variable Annuity Right for You?

Variable annuities come with tax advantages, but they can be expensive. Ideally, you should max out your contributions to your 401(k) and IRA before putting money in an annuity of any kind. That’s because annuities are much more advanced products, which makes them better as secondary savings options. Of course, if you’re already maxing out your 401(k) and IRA contributions, a variable annuity could be worth it.

If you have a 401(k) and you fund your variable annuity with pre-tax dollars from it, you’re not maximizing the tax benefits. For the most tax-deferred growth, you should put any savings outside of your 401(k) balance in the annuity. Of course, if your company offers an annuity in your 401(k), you could do both.

Bottom Line

Weigh the pros and cons of whether a variable annuity is the right choice for your retirement plan.

Variable annuities can be pricey, and if that turns you off of them then you may want to consider investing on your own through a brokerage account. Although you’ll miss out on the tax-deferred growth, your fees will be much lower. Then when the time comes to retire, you can buy an immediate annuity if you want the lifetime income stream. If you’re still not sure, a financial advisor can help you make that decision.

Tips for Retirement Planning

  • Purchasing an annuity can help save for retirement, but so can 401(k)s and IRAs. If you need help putting together a large-scale retirement plan, you can consider reaching out to a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • The two main retirement accounts most Americans own are 401(k)s and IRAs. To figure out which is best for you, take a look at SmartAsset’s guide to IRAs vs. 401(k)s.

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