What a variable annuity is and how it differs from fixed annuities

A variable annuity is an insurance contract where the payments you receive depend on how well the underlying investments perform, rather than on a rate set when you buy the contract. With a fixed annuity, the insurance company guarantees you a specific payment amount for life or a set period. With a variable annuity, you choose from a menu of investment options—usually mutual funds—and your payment fluctuates based on whether those investments gain or lose value.

The trade-off is straightforward: you accept the risk that your payments might drop in exchange for the possibility that they might grow. If your investments perform well, your annuity payments increase. If they perform poorly, your payments decrease. This is why variable annuities appeal to people who believe they can tolerate market risk and want the potential for higher long-term income than a fixed annuity would provide.

Variable annuities are issued by insurance companies, but the investment portion is regulated by the Securities and Exchange Commission (SEC) because it involves securities. This dual regulation means you receive both an insurance contract and a prospectus—a detailed disclosure document about the investment options available to you.

Key Takeaways

  • Your variable annuity payments rise or fall based on the performance of the investment subaccounts you choose, not on a may provide rate.
  • You select from a menu of investment options—typically mutual fund-like portfolios—when you purchase the annuity and can usually change your allocation later.
  • Variable annuities charge multiple layers of fees: mortality and expense charges, investment management fees, and often rider fees for added protections.
  • The insurance company guarantees to convert your accumulated value into income payments at a specified rate, but the payment amount itself depends on investment performance.
  • Variable annuities are long-term contracts with surrender periods; withdrawing money early usually triggers a penalty, and withdrawals before age 59½ may incur a 10 percent tax penalty.

How the investment subaccounts work

When you purchase a variable annuity, you deposit a lump sum or make regular contributions. That money does not sit in a single account; instead, you direct it into one or more subaccounts—investment portfolios managed by the insurance company or third-party investment firms. Each subaccount typically tracks a specific investment strategy: aggressive growth, balanced, international stocks, bonds, money market, or sector-specific funds.

You decide how to split your money among these subaccounts. If you choose 50 percent in a stock-focused subaccount and 50 percent in a bond-focused subaccount, your annuity value will move up or down based on how those two investment categories perform. Unlike a mutual fund, where you own shares directly, you own units in the subaccount, and the value of those units changes daily based on the underlying securities' market prices.

Most variable annuities allow you to rebalance or reallocate your subaccount choices periodically—sometimes quarterly or annually, sometimes without restriction. This means you can shift money between subaccounts if your risk tolerance changes or if you want to adjust your strategy. However, some annuities limit the number of free transfers per year; additional transfers may incur a fee.

The fee structure: what you actually pay

Variable annuities are often criticized for their complexity and cost. Understanding the fee layers is essential because they directly reduce your returns and the income you eventually receive.

Mortality and expense (M&E) charges are the insurance company's primary fee. These typically range from 0.5 percent to 1.5 percent of your account value annually and cover the cost of the insurance may provide (that the company will convert your money into income) and administrative expenses. This fee is deducted automatically from your subaccount values.

Investment management fees are charged by the subaccount managers and vary by subaccount. A stock fund subaccount might charge 0.5 percent annually, while a bond subaccount might charge 0.3 percent. These fees are embedded in the subaccount's daily value, so you do not see a separate bill, but they reduce your returns.

Rider fees are optional add-ons that provide extra protections or guarantees. A may provide minimum income rider, for example, might may provide that your annuity will pay you a minimum income amount even if your investments perform poorly—but this protection costs an additional 0.5 percent to 1 percent annually. Other riders might may provide a death benefit or provide long-term care insurance.

Combined, these fees can total 2 to 3 percent or more of your account value each year. Over decades, this compounds significantly. A variable annuity with 2.5 percent in annual fees will grow much more slowly than an identical investment portfolio with 0.2 percent in fees, all else equal.

How annuitization converts your balance into income

At some point—often when you retire or reach a specified age—you can choose to annuitize your variable annuity. This means you convert your accumulated account balance into a stream of regular income payments, usually monthly or quarterly, for the rest of your life or for a set period.

The insurance company uses a formula to calculate your payment amount. That formula depends on three things: your account balance at the time of annuitization, your age, and current interest rates. The company also offers different payout options: life only (payments stop when you die), life with a period certain (payments continue to a beneficiary if you die within a set number of years), or joint and survivor (payments continue to a spouse after your death).

Here is the crucial point: the insurance company guarantees to make those payments for as long as the option specifies, regardless of investment performance. However, the payment amount itself was calculated based on your account balance, which depends on how your subaccounts performed. If your investments grew significantly, your balance is larger and your payment is higher. If they declined, your balance is smaller and your payment is lower.

Some variable annuities also offer a may provide minimum income rider, which promises a minimum payment amount even if your account balance falls below a certain level. This rider provides downside protection but costs extra in annual fees.

Surrender periods and early withdrawal penalties

Variable annuities are designed as long-term contracts. When you purchase one, you enter a surrender period—typically 5 to 10 years, though some extend to 15 years. During this period, if you withdraw money beyond a small annual allowance (often 10 percent of your account value), you pay a surrender charge—a percentage of the withdrawal amount that declines each year you hold the contract.

For example, if your surrender period is 7 years and you withdraw 50 percent of your account in year 3, you might pay a 5 percent surrender charge on that withdrawal. In year 7, the charge might be 1 percent. After the surrender period ends, you can withdraw your full balance without a surrender charge, though you still owe income tax on any gains.

Additionally, if you withdraw money before age 59½, the IRS imposes a 10 percent early withdrawal tax penalty on the earnings portion of your withdrawal (not on your original contributions). This penalty is separate from the surrender charge and applies regardless of how long you have held the annuity. Combined, a surrender charge and an early withdrawal penalty can significantly reduce the amount you actually receive.

Tax treatment and when you pay taxes

Variable annuities grow tax-deferred, meaning you do not pay income tax on the investment gains, interest, or dividends inside the annuity each year. This is a major advantage compared to holding the same investments in a taxable brokerage account, where you would owe tax annually on dividends and capital gains.

However, you do pay tax when you withdraw money or receive annuity payments. If you withdraw a lump sum, the IRS treats withdrawals as coming from earnings first (under the "last-in, first-out" rule for annuities), so your early withdrawals are taxed as ordinary income. Once you annuitize and begin receiving regular payments, each payment is partly a return of your original contribution (tax-free) and partly earnings (taxable as ordinary income). The insurance company calculates this split using IRS life expectancy tables.

If you purchased the variable annuity with pre-tax money (such as through a 403(b) plan or traditional IRA), all withdrawals and payments are taxed as ordinary income. If you purchased it with after-tax money, only the earnings portion is taxed. Keep your purchase documentation to prove how much was after-tax, because the IRS will ask.

When a variable annuity might make sense

Variable annuities are most useful for people in specific situations. If you have a large sum to invest, expect to live a long time, and want may provide lifetime income with growth potential, a variable annuity can provide that. The tax deferral is valuable if you are in a high tax bracket and expect to be in a lower bracket in retirement.

They are also worth considering if you want insurance-backed guarantees—such as a may provide minimum income or a death benefit—that you cannot easily replicate by holding mutual funds and bonds separately. Some people also value the forced discipline of annuitization: converting a lump sum into income you cannot outlive appeals to those who worry about spending down their savings too quickly.

However, variable annuities are rarely the best choice for people who need access to their money within the next 7 to 10 years, who are uncomfortable with investment risk, or who are price-sensitive to fees. For those groups, a fixed annuity, a bond ladder, or a diversified portfolio of low-cost index funds may be more appropriate.

Frequently Asked Questions

Can I change my subaccount allocation after I buy the annuity?

Yes, most variable annuities allow you to reallocate your money among subaccounts. Some permit unlimited transfers, while others allow a set number per year (often four) before charging a fee. Check your contract's prospectus to see what your specific annuity allows.

What happens to my variable annuity if the insurance company fails?

Insurance companies are regulated by state insurance commissioners, and most states have a guaranty fund that protects annuity holders up to a limit (often $250,000 per person per company) if an insurer becomes insolvent. This protection covers the insurance guarantees but not investment losses. Research the financial strength of the insurance company before purchasing.

Is a variable annuity better than just buying mutual funds?

It depends on your goals. Mutual funds offer lower fees, more flexibility, and easier access to your money. Variable annuities offer tax deferral, may provide lifetime income through annuitization, and insurance-backed guarantees. If you want may provide income for life and can tolerate the fees and surrender period, a variable annuity may be worth it. If you want flexibility and low cost, mutual funds are usually better.

Do I have to annuitize my variable annuity?

No. Many variable annuities allow you to withdraw your balance as a lump sum or in systematic withdrawals without annuitizing. However, if you choose not to annuitize, you lose the insurance company's may provide of lifetime income, and you bear the risk of outliving your money. Some annuities require annuitization at a certain age; check your contract.

What is the difference between a variable annuity and a variable universal life insurance policy?

Both offer investment subaccounts and variable returns, but they serve different purposes. A variable annuity is designed to convert savings into retirement income. A variable universal life policy is life insurance with an investment component; its primary purpose is to provide a death benefit to beneficiaries. The tax treatment and fee structures also differ significantly.