A variable annuity can offer you tax-deferred growth, a wider range of investment options and guaranteed income. However, it comes with potential risks. And the success of your investment will hinge of your ability to avoid surrender charges and liquidity restrictions, and be aware of high fees and market risks. Here’s what you need to know.
A financial advisor can help you determine whether a variable annuity is a good fit for your retirement plan.
How a Variable Annuity Works
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, the 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.
How Variable Annuities Differ From Fixed Annuities
Variable annuities offer potentially higher returns and tax-deferred growth, but can lead to losses due to market instability. Comparatively, fixed annuities can provide guaranteed returns, but may not keep up with the pace of inflation.
Additionally, while a fixed annuity can offer you a guaranteed interest rate, it will come with less investment flexibility and a smaller opportunity for growth. This annuity typically invests in fixed-income securities like bonds and other fixed-interest instruments. Whereas variable annuities can invest in equity funds, bond funds, money market funds, and other investment options.
When it comes to taxation, both annuities tax withdrawals as ordinary income. And both annuities could also charge you a surrender fee if you take out funds during the accumulation phase. You may also face an early withdrawal fee of 10% from the IRS if you make a withdrawal before age 59½.
Bottom Line
A variable annuity can be a good investment for retirement if you are looking for a combination of tax-deferred growth and flexibility when choosing investments. However, you should be aware of the risks that could lower the value of those investments, and the terms of your annuity, which could impose fees and penalties.
Tips for Retirement Planning
- When you’re planning for retirement, it’s important to know what your long-term goals are and what investment options will help you get there. A financial advisor can be a great resource in helping get to where you want to go. They can provide expert advice or manage your investments for you. 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.
- A retirement calculator can help you estimate if you’re saving enough money for the retirement you’re looking for.
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