A variable annuity is hard to classify. It’s an investment, a retirement plan, and an insurance contract rolled into one.

Annuities are tax-deferred retirement savings plans offered by insurance companies. You purchase an annuity from an insurer and sign a contract agreeing to pay a premium, or certain amount of money, either as a lump sum or over time.

The insurer credits the premium and earnings to your account. When you’re ready to begin withdrawing the money, the insurer will, if you choose, annuitize your account value, which means converting it to a stream of lifetime income. You’ll typically have other withdrawal options, too, including taking the money as a lump sum or receiving systematic payments over a period of time.

Variable annuity basics

With a variable annuity — which does not have a predetermined rate of return the way a fixed annuity does — you decide how your premium is invested by choosing from among a number of subaccounts, or investment options, which the annuity contract offers.

Subaccounts resemble mutual funds in some ways. Each subaccount holds a portfolio of underlying investments — stocks, bonds, cash equivalents, or a combination of stocks and bonds — purchased with money pooled from different investors. Your return depends on how well the subaccounts you’ve selected perform, which in turn is based on the performance of the specific investments in the subaccounts you’ve chosen, what’s happening in the market as a whole, and fees and expenses.

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The variable annuities fees

Variable annuities have annual, asset-based fees, just as mutual funds do, but, on average, annuity fees are higher. This means you must earn more on a subaccount than on a comparable mutual fund to have the same total return. The details of these fees — how they’re calculated and when they’re debited from your account — are described in the annuity’s prospectus.

In addition, many annuities have surrender fees — up to 7% or more of the amount you invest — if you end the contract during the surrender-charge period, typically seven to ten years from the time you purchase the annuity. While some mutual funds similarly impose trading restrictions or redemption fees, fund fees usually remain in effect for a matter of days or months, not years.

Insurance protection debate

Most variable annuity contracts include a death benefit for which you pay a mortality and expense (M&E) fee. The death benefit guarantees that your beneficiaries will receive at least as much as you paid in premiums if you should die before you begin to receive annuity income. Some contracts may also lock in gains on a regular schedule. This means your beneficiaries would receive more than the premiums you paid into the annuity, even if the account balance drops below the principal amount.

However, these guarantees, like guar an tees for lifetime income, depend on the claims-paying ability of the company issuing the insurance.

Annuity advocates argue that having this protection encourages people who might otherwise avoid investing to benefit from its potential rewards while being insured against total loss.

Critics of annuities, and of the death benefit provision in particular, point out that M&E fees typically cost more than they’re worth — unless the market takes a dramatic turn for the worse right after you purchase the annuity and you die immediately.

Every state has a law requiring a free-look period on annuities and life insurance. The period varies from state to state, but you generally get at least ten days from the day you buy an annuity to cancel it and get your money back without paying surrender charges.

Tax issues

Earnings in a variable annuity grow tax deferred, and are taxed at your regular income tax rate when you begin withdrawals, usually after you’re at least 59½. However, early withdrawals before you reach 59½ may be subject to a 10% federal tax penalty.

Unlike money invested in a deductible IRA or employer sponsored plan, such as a 401(k), you invest post-tax income in a variable annuity that you purchase on your own. When you receive income from the annuity, a portion of the payment is a tax-free return of your premiums.

Also unlike traditional IRAs and employer plans, nonqualified annuities don’t require you to begin withdrawals when you turn 70½. In fact, you can usually postpone taking income until you’re 80, or even 90 in some states. You may also find that an annuity is one of the options available in your employer sponsored plan — especially if it’s a 403(b). Then, your contributions as well as your earnings are tax deferred and, in most cases, you’re required to begin taking withdrawals when you retire or reach 70½, whichever comes first.

Variable Annuities

Subaccount transfer

You can typically transfer money among subaccounts in a variable annuity without charge if you want to reallocate your assets or rebalance your portfolio. Each contract explains the terms of the transfers it allows.

There may be a market value adjustment (MVA) on transfers out of a fixed-income subaccount offered in the annuity. For example, if you wanted to move $10,000 from a fixed account to an equity account after interest rates have gone up, you might be able to move only a portion of the total. The balance would go to the annuity provider.

Rating annuity providers

One of the primary concerns in choosing an annuity is knowing whether or not the provider is going to be able to meet its long-term commitments. One way to make this assessment is to check out the company’s financial situation by using evaluations provided by professional rating services. For example, both Standard & Poor’s and Moody’s Investors Service measure financial strength and ability to pay.

With a variable annuity, the principal you allocate to subaccounts — other than those that provide a fixed return — cannot be seized by the insurance company’s creditors. But you’re still dependent on the insurer to pay you lifetime income once you annuitize. Since that’s money you’ll be counting on, finding an insurer that is likely to meet its obligations to pay is of paramount importance.

What Are Variable Annuities Investments? by Inna Rosputnia

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