What a variable annuity is

A variable annuity is an insurance contract where you give money to an insurance company, and in return they promise to pay you income later — but the amount you receive depends on how well the investments inside the contract perform. Unlike a fixed annuity, which pays you a set amount each month, a variable annuity's payout rises or falls based on the value of the investment accounts you choose within it.

You pick from a menu of investment options — usually mutual funds — and your money grows or shrinks with those investments. When you start taking income, the insurance company divides your account value by a number of years (or uses other formulas) to calculate your monthly payment. If your investments do well, your payment goes up. If they do poorly, your payment goes down.

Key Takeaways

  • Variable annuities tie your income payments to investment performance, so your monthly check changes based on how the underlying funds perform.
  • You pay ongoing fees — typically 1% to 3% per year — for the insurance wrapper, investment management, and optional riders that may provide certain payouts.
  • Your money is locked in: withdrawing more than a small amount before age 59½ usually costs you a 10% tax penalty plus income tax, and early withdrawals from the annuity itself may trigger surrender charges.
  • Variable annuities are complex contracts with many moving parts, and the fees and restrictions make them more expensive than straightforward buying mutual funds on your own.

How the investment portion works

When you buy a variable annuity, the insurance company opens a separate account for you and lets you choose how to invest the money. The options are typically mutual funds managed by the insurance company or a partner firm. You might choose an aggressive stock fund, a conservative bond fund, or a mix of both.

Your account value changes daily based on how those funds perform — just like a regular mutual fund account. The difference is that this account is inside an insurance contract, which adds layers of fees and restrictions. You can usually move money between the investment options within the annuity without triggering a tax event, but you cannot easily take the money out without penalties.

Fees you will pay

Variable annuities are expensive. You typically pay multiple layers of fees each year:

  • Mortality and expense risk charge: Usually 0.5% to 1.5% per year. This is the insurance company's fee for taking on the risk of your contract.
  • Investment management fees: Usually 0.5% to 2% per year, depending on which mutual funds you choose within the annuity.
  • Administrative fees: Flat dollar amounts, often $25 to $100 per year, for record-keeping and customer service.
  • Rider fees: If you add optional guarantees (see below), you pay extra — often 0.5% to 2% per year for each rider.

Combined, these fees often total 2% to 4% per year. Over time, this compounds. A 3% annual fee means that after 20 years, roughly half your gains go to fees instead of staying in your account. You can buy a diversified portfolio of mutual funds outside an annuity for 0.1% to 0.5% per year, which is why many financial advisors question whether the insurance features justify the extra cost.

Surrender charges and withdrawal restrictions

When you buy a variable annuity, you typically agree to keep your money in the contract for a set period — often 5 to 10 years. If you withdraw more than a small amount (usually 10% per year) before that period ends, the insurance company charges you a surrender charge. This penalty typically starts at 5% to 7% of the amount withdrawn and decreases by 1% each year until the surrender period ends.

On top of the surrender charge, if you are under age 59½, the IRS adds a 10% tax penalty on the withdrawal, plus you owe income tax on any gains. This means pulling out $10,000 early could cost you $1,000 in surrender charges, $1,000 in the IRS penalty, and income tax on top of that — easily 30% to 40% of what you withdraw.

The surrender period is one of the biggest reasons people regret buying variable annuities. If your circumstances change and you need access to your money, the penalties are steep.

Optional guarantees (riders)

Insurance companies sell variable annuities with optional add-ons called riders that promise to protect you in certain situations. Common ones include:

  • may provide Minimum Income Benefit (GMIB): Guarantees a minimum monthly payment even if your investments perform poorly, but you pay 0.5% to 1.5% per year for this protection.
  • may provide Minimum Withdrawal Benefit (GMWB): Lets you withdraw a set percentage of your account each year, may provide, regardless of investment performance.
  • Death benefit rider: Guarantees your beneficiary receives at least what you put in, even if the account value has dropped.

These riders sound appealing — who would not want a may provide? But they cost money every year, and the may provide only applies under specific conditions. Read the fine print carefully. Many riders have restrictions on when you can use them, how much you can withdraw, and what happens if you need the money before a certain age.

When variable annuities might make sense

Variable annuities are rarely the best choice for most people, but there are narrow situations where they might fit:

  • You have a large sum of money, want may provide income in retirement, and are willing to pay for that may provide through ongoing fees.
  • You are concerned about outliving your money and want the insurance company to take that risk off your hands.
  • You have already maxed out retirement accounts like a 401(k) or IRA and want tax-deferred growth on additional savings (though this is a weak reason, since the fees often outweigh the tax benefit).

Even in these cases, compare the total cost of the variable annuity to simpler alternatives: a low-cost mutual fund portfolio, a fixed annuity, or a combination of both. Many people buy variable annuities because a salesperson explained only the benefits, not the full cost and restrictions.

Variable annuities versus fixed annuities

A fixed annuity pays you a set amount each month for life, no matter what happens in the markets. A variable annuity ties your payment to investment performance. Fixed annuities have lower fees (usually 0.5% to 1% per year) and simpler terms. Variable annuities offer the possibility of higher income if investments do well, but also the risk of lower income if they do poorly.

If you want predictability and simplicity, a fixed annuity is usually cheaper and easier to understand. If you want growth potential and are comfortable with investment risk, you might be better off buying mutual funds directly rather than wrapping them in an annuity contract.

Frequently Asked Questions

Can I get my money out of a variable annuity early?

You can withdraw money, but it will likely cost you. Before the surrender period ends (usually 5 to 10 years), you pay a surrender charge of 5% to 7% of the withdrawal amount, declining each year. If you are under 59½, add a 10% IRS penalty plus income tax on gains. Many people find these costs prohibitive.

What is the difference between a variable annuity and a mutual fund?

Both invest your money in funds that rise and fall with the market. The key difference: a mutual fund has low fees (often under 0.5% per year) and you can withdraw your money anytime. A variable annuity wraps those investments in an insurance contract, charges 2% to 4% per year in fees, locks your money in for years, and adds complexity. You pay for insurance features you may never use.

Do I have to take income from a variable annuity at a certain age?

No required minimum distributions exist for variable annuities the way they do for IRAs. However, if you bought the annuity with pre-tax money (like a rollover from a 401(k)), you will owe income tax on withdrawals. Check your contract for any age-based restrictions on when you can start taking payments without penalties.

Are variable annuities safe?

Your money is backed by the insurance company's financial strength, not by the FDIC or any government may provide. If the insurance company fails, your account is protected only up to state-specific limits (usually $100,000 to $500,000 per state). Research the insurance company's financial rating before buying.

Should I buy a variable annuity?

Most financial advisors recommend against them for most people because the fees are high and the restrictions are tight. Before buying, compare the total cost (all fees and surrender charges) to simpler alternatives like a low-cost mutual fund portfolio or a fixed annuity. Get a second opinion from an advisor who does not earn a commission on the sale.