Understanding Variable Annuities

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Anyone preparing for retirement knows how important it is to explore their investment options. But while most people think of a 401(k) or IRA as their best choice for investing long-term, they might be surprised to learn the benefits of a variable annuity. If you’re looking for a smart and lucrative place to invest for your retirement, it’s vital to understand this type of investment plan.

What is It?

Essentially, a variable annuity is an investment in one or more mutual funds, which is wrapped in an annuity contract that provides insurance-type retirement benefits. These include living benefits, death benefits, and so on, and are in many ways similar to a life insurance policy.

While it may be tempting to view an annuity as little more than a mutual fund investment, the reality is that these plans offer many distinct advantages. Unlike a basic mutual fund, a variable annuity offers:

• Periodic payments A variable annuity allows you to be paid periodically (usually monthly), for a specified amount of time during the payout period. This feature makes annuities more convenient than mutual funds, as they can be set up to make sure you don’t outlive your account balance.

• Death benefits Similar to life insurance, annuities provide a death benefit in the event of your untimely passing. If you die before your account balance is paid out, you have a number of options for how you can have it distributed to your beneficiary. And while death benefit payments are always equal to at least the original principle on the account, you can also arrange for it to pay out the account balance rather than the principle.

How Does it Work?

Now that you know the basic idea behind a variable annuity, you may be wondering, “How does a variable annuity work?” Variable annuities are not difficult to understand, and are made up of two stages:

• Accumulation During the accumulation period, you place money into the annuity in either a single payment or multiple purchase payments over time. You can place your money into different investments (i.e. stocks, bonds, money market instruments, etc.), which allows you enough room to diversify your money. Additionally, annuities normally allow a few free transfers between accounts, and you can even withdraw up to 10 percent of your account yearly without a fee. Any withdrawals over 10 percent are taxed 7-12 percent, and the percentage diminishes until the end of the “surrender period” (usually 7-12 years).

• Distribution Once you reach the distribution period (a specified time after age 60), your account balance is paid out over a time period determined by your age, life expectancy, and other factors. These payments are usually made monthly, and the payments vary based on the performance of your investments. However, you may also have the option to fix your payments (a fixed annuity), or make them variable with a predetermined minimum payment.

Variable and equity-indexed annuities are also a guaranteed income stream. There are several pros and cons of equity-indexed annuity guarantees, though, so make sure to research them thoroughly.

How is it Taxed?

One of the most attractive features of a variable annuity is that it is untaxed until your account is paid out. Aside from this benefit, there are also no taxes on transferring money between investment accounts, although the holder of your annuity may leverage a small fee for doing so.

When an annuity finally reaches the distribution period, your payments are taxed as normal income. While this is a higher rate than you might pay on some other investments, the untaxed accumulation period ensures that you will save money in the long run.

What Are the Costs, Fees, and Other Expenses?

Variable annuities have a bad reputation for being more expensive than other investment options, which is not entirely unfounded. In addition to the investment management fee charged by mutual funds, annuities also incur a 1.25 percent yearly “mortality expense” to cover the death benefit, as well as a $25-$30 flat fee to pay for administrative and record-keeping tasks. Also, many of the contract customizations mentioned above result in higher yearly fees.

While all these fees add up over time, you should consider the benefits of a variable annuity and decide if they may be worth your money. However, also decide if you can reap such benefits from a different plan, such as a life insurance policy or 401(k).

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Ultimately, the important thing to remember about variable annuities is that each plan is different. You should carefully read over the prospectus of any plan before agreeing to a contract, and consider if the annuity holder offers any benefits you can leverage in your favor.  If well-planned, an annuity can be one of the most important assets for preparing for your retirement.