A variable annuity is a tax-deferred retirement vehicle that allows you to choose from a selection of investments, and then pays you a level of income in retirement that is determined by the performance of the investments you choose. Compare that to a fixed annuity, which provides a guaranteed payout.
Unlike their fixed counterparts, variable annuities are designed to pump up your savings by giving you a chance for long-term capital growth. They do this by allowing you to invest in anything from half a dozen to 20 or so stock or bond mutual-fund-like portfolios called subaccounts. As with fixed annuities, gains escape taxation until withdrawal.
Because of the growth potential, a variable annuity may be more likely than a fixed annuity to outpace inflation.
Variables have several drawbacks that can erode their advantages. For starters, there’s a lot more risk associated with a variable annuity.
Investment risk: If the investments you choose for your annuity decline, the value of your annuity will also decline – and that means a lower payout to you.
Taxes: Then there are the taxes. As with fixed annuities, you’ll pay taxes on a variable annuity’s gains when you withdraw them, plus a 10% penalty if you’re under age 59 ½. Variables also have another little tax twist: Any long-term capital gains you build up in stock and bond subaccounts are taxed at ordinary income rates when you withdraw them. This means that high-income investors are effectively converting long-term capital gains taxed into ordinary income that can face far higher rates.
Fees: And then there are variables’ fees. Aside from surrender charges that dock you for early withdrawals, variables can also come with steep sales commissions (often 4%). Add ongoing management fees and insurance charges, which combined can run as high as 2% to 3% a year, and you’re looking at one hefty load of fees cutting into your returns.
Compare that fee structure with regular no-load mutual funds, which levy no sales commission or surrender charge and impose average annual expenses of less than 0.50% (for index funds) or about 1.5% (actively managed funds).