A variable annuity, similar to any other annuity, represents a legal contract with an insurance carrier. There are two components within the annuity. There is an investment component and an insurance component. Let’s start by looking at the investment component of a variable annuity.
The Investment Component in a Variable Annuity
When you purchase a variable annuity, you get to pick how the funds will be invested. The returns on your account will differ depending on the overall performance of the investment funds you select.
This is the reason it is known as a variable annuity. In contrast, with a fixed annuity the applicant does not determine the investments; rather, the insurer invests your funds and offers you a specified guaranteed return on your investment, a lot like how a traditional CD works.
You are permitted to choose investments within the variable annuity from a pre-selected listing of investment funds (also known as sub-accounts) which can vary from aggressive stock funds to conservative bond funds. The sub-account selections could be international stock funds, blue-chip stock funds, small-cap stock funds, precious metals, balanced choices, various types of bond funds, and money markets. The majority of variable annuities also contain model portfolios that are available for you to pick from.
You are generally allowed to set up your investments in your variable annuity so that they automatically rebalance on a preset schedule (such as annually or quarterly), or you can easily log on to your account and change investments around as you see fit.
One of the promoted benefits of variable annuities is that since you are allowed to select your own investments, you could essentially achieve greater long-term returns than what a fixed annuity would likely pay. This feature can boomerang, however, since the higher fees in a lot of these variable annuity contracts commonly perform worse than a portfolio of index funds.
The Insurance Component in a Variable Annuity
Because your variable annuity is a contract between you and an insurance company, there needs to be some kind of insurance provided. Most annuity plans promise that the amount you invested into the account will be paid out as a death benefit when you die. This implies if your financial investments sustain a loss, and then you die, your designated beneficiary will get the original amount you invested minus any withdrawals). This death benefit enables the annuity contract to meet the requirements of an insurance contract.
Since your variable annuity qualifies as an insurance contract, your investment earnings will be tax-deferred. You will not receive a 1099 tax form from the insurance company each year on interest, dividends, and capital gains from the annuity. Rather, you will pay any taxes at the time you make a withdrawal, and increases are considered to be taken first. If you remove funds before reaching age 59 1/2, a 10% early withdrawal penalty will probably apply to any portion of funds withdrawn that is connected to investment earnings.
Investors in higher tax brackets with long-term time frames (20 years or more) will probably benefit from the tax deferral, especially if they use their variable annuity to accommodate fixed-income investments that would typically produce taxable interest income each and every year.
Many years of a tax deferral on your investment income that will accumulate within your variable annuity can make great financial sense for those investors in high income tax brackets now, especially if they anticipate they will be in a lower income tax bracket later.
Most investors, unfortunately, will not benefit from the income tax deferral characteristics of a variable annuity due to the fact that capital gains in the annuity will eventually not be permitted to be taxed at the much lower capital gains tax rate.
Available Optional Benefits
Most of the insurance companies that offer variable annuities also offer additional optional insurance benefits that you can select and purchase, such as death benefit riders that will furnish benefits for your surviving family members, and living benefit riders, which can offer guarantees as to the income you will withdraw from the policy at a later date. Lots of variable annuities also provide preferred treatment on withdrawals for the objective of long-term care costs. These optional riders typically have an additional charge – so you can add preferred benefits to your variable annuity contract.
When purchasing a Variable Annuity Makes Sense
Where variable annuities will be worth consideration is if you have maxed out your investment into other tax-advantaged accounts. If this is the situation – and you want the financial peace of mind that lifetime payments will provide – then variable annuities warrant your consideration.
Whether you live in Chillicothe, Ohio or anywhere else for that matter, it’s critical that you learn the pros and cons of any investment product and especially how it may or may not benefit your circumstances.