What is a Variable Annuity and What Should You Know About it?
A variable annuity offers high growth potential for people with a high-risk appetite and want a steady income as soon as they begin their life post-retirement. Variable annuities are a type of investment contract between the investor and the insurance company or the annuity company, wherein the investor gets periodic payments after a set duration of time, as specified by the agreement. When you invest in a variable annuity, you must know that your investment is tied with the growth potential the market has to offer.
A variable annuity is similar to other investments. You choose where you want to invest your money based on what mode gives you the highest return. The annuity company then begins managing your money, and you can get your corpus along with returns in the long run. The returns solely depend on how well your chosen investments perform over the time span you have opted for. If the performance of your portfolio has been satisfactory, you will get your invested sum back along with the additional profit you would have earned from the investment. However, if your investments did not do too well, there is a chance that the value of your initial investment may decline. There is a huge potential for high returns with variable annuity, however, the risk is also substantial.
The key thing to remember here is that a variable annuity does not function as “one size fits all”. Every variable annuity is unique and crafted to cater to an individual investor’s needs. You can choose and customize your annuity based on your needs keeping the risk factor in mind.
Introduction to variable annuities
A variable annuity is a unique investment option where you get a regular income throughout your life or for a specified duration of time. You begin by signing up with an annuity company that invests your money in the market. Your money could be invested entirely in stocks or entirely in bonds. The annuity company you choose may also carefully allocate 50% of your money to stocks and 50% of it to bonds to minimize the risk factor. This way, even if the price of the stock the company invested in goes down, you can rest assured that all of your money won’t lose its worth.
On the bright side, you can choose an investment portfolio that best caters to your needs and is in tandem with your risk appetite and objectives in life. Investors must be careful at this juncture that the amount of returns you get on your investment may increase or decrease depending on the performance of your portfolio. It is important to note that there is a chance of you losing the money you invested. You have a range of investment options to choose from to maximize the amount of your returns. Your money may also be invested in mutual funds which further invests the money in stocks, bonds, etc.
For example, let’s assume that your portfolio is heavy in mutual funds that invest primarily in stocks.
Due to whatever reason, if the stock market becomes bearish and the stock prices across the board start to tumble, most of the stocks in the portfolio will tumble too, bringing you loss. As a result, the mutual fund return will also fall. In such a situation, not only will you not get any returns on your investment, but your initial investment may also reduce. Two factors determine the true value of a variable annuity: the amount of your investment in the annuity and the returns you get on your investment in the long run. The best part about a variable annuity is the fact that your investments can grow on a tax-deferred basis. You will only have to pay taxes when you take the money out later in life.
Another advantage to putting your money in a variable annuity is the insurance benefit that it gives to the investors. If the investor passes away before the annuity company can begin paying out the returns to the investor, the beneficiary may get a payout. The amount depends on the contract you sign with the annuity company. In other words, not only do you get retirement benefits with a variable annuity, but you also gain an insurance feature on the annuity. God forbid, should you have an untimely death, your beneficiary may get some financial padding to make life a little bit easier for them.
A variable annuity is also a blessing in disguise for individuals with a high taxable income. When you put your money in a variable annuity, your money grows tax-deferred. In other words, you will owe no federal taxes on the income and returns accrued on the variable annuity over time. You will only be required to pay taxes when you withdraw the amount. The same taxation will be levied if a death benefit is paid by the annuity company to your beneficiary. The tax-deferred benefits are only applicable to investors with a variable annuity if the investment is held for a long period.
How does a variable annuity work?
First, you need to identify an insurer that offers a variable annuity. Once you have found a variable annuity company, you will have to choose your investment portfolio under the guidance of a professional insurer. You will be asked to choose accounts and subaccounts, and choose how you want the money in your portfolio to be allocated.
You then start by making payments in line with your portfolio requirements. When it comes to payments, you have the option of paying a lump-sum amount to the company or making small payments over a set period.
Variable annuities function in two phases: the accumulation phase and the payout phase.
In the accumulation phase, you will make the payments to the company as per your contract. The accumulation phase allows you to transfer your investment from one option to the other without having to pay any kind of taxes on it. If at any point, you feel like withdrawing your investment before maturity, you may be allowed to do so, but at the cost of ‘surrender charges’. It is prudent to mention here that some variable annuities come with a ‘free look’ period – a trial period of 10 days. There is no charge if you choose to exit within 10 days.
The accumulation phase will be followed by the payout phase where you start receiving the returns after a specific duration. You may choose to receive your returns in one go as a lump-sum amount or you can get it as a stream of payments over a set duration of time. It is up to you to decide the duration you want to get the benefits for – from 5 years to your entire lifetime.
Remember, you can take out money from the variable annuity without a penalty only after 59.5 years of age. Should you choose to withdraw money from a variable annuity before 59.5 years of age, you will be charged a 10% penalty on the withdrawal.
Why should you get a variable annuity?
A major reason why getting the variable annuity is a good idea is the fact that the rate of returns in a variable annuity could be higher than other quintessential investment options there are in the market, especially as retirement products. You can protect yourself from inflation with the high returns that a variable annuity offers you.
The money you put in a variable annuity is tax-deferred and you will not have to pay any taxes on the money you invest. Like other traditional retirement and 401(k) accounts, you will only have to pay taxes on the gains you get when you withdraw the money.
Variable annuities are often recommended as the best retirement plans for individuals with high net worth and people who pay higher income tax. Unlike 401(K) retirement accounts and Roth IRA accounts, there is no capping on putting money in a variable annuity. You can put as much money as you can spare in your variable annuity each year. If you have crossed the threshold of putting money in your 401(K) account or your Roth IRA account, putting money in a variable annuity is a wise choice since it allows you to be better prepared for your retirement. Who knows, you may even retire early based on how positively your investments perform.
Putting money in a variable annuity is beneficial because of its special feature to help protect your investment from losses. There is a rider that you can purchase which guarantees that you will get at least the entire amount of your investment back, even if your investment makes negative gains. There is an added cost to get a rider, but it will protect your money from losses that may be accrued if the market does not perform as expected. Variable annuities also allow for long-term capital growth via investment in sub-accounts.
You can even organize a variable annuity for the future, an option that you can purchase at an extra cost. You get the advantage of lifetime income with variable annuities at a minimal charge which will ensure that your stream of payments outlives you and can be passed to your spouse or beneficiaries.
Variable annuities not only give a steady income in your retirement, but they also act as insurance. Your beneficiary can get a death benefit and get at least the amount you invested in a variable annuity upon your death.
Things to look out for when investing in a variable annuity
Read the contract drafted by the annuity company to the dot before signing it. Understand all the benefits you are being given, all the charges that are being levied, and clear any doubts with your agent. It is better to be wary about what you are buying than complain about it later. You will have to pay about 1.25% per year as a mortality and expense risk charge. You will additionally have to pay a small percentage towards administrative expenses each year. Each rider to protect your investment can cost anywhere from 0.25% to 1% per year. If your money is invested in mutual funds, you will also have to pay an annual fee for the mutual fund company.
Remember, variable annuities are customizable; make sure you convey your needs to your agent before a contract is drafted. Carefully scrutinize and understand the risk factor in the investment you are about to make. No question is too silly when you’re investing thousands of dollars into a plan to secure your retirement.
If you wish to withdraw your investment, you will have to pay surrender charges to the annuity company. Surrender charges are a hefty penalty for withdrawing your investment before the set duration of time. The surrender period is typically 6-8 years after you sign the contract. So if you make a withdrawal in these 6-8 years, you will be levied a penalty for doing so.
The surrender charges sometimes drop over the years. For example, if there is a 10% surrender charge of your variable annuity, and you want to withdraw it in the first year itself, you will have to pay 10% of the money as a fine. If you withdraw it the year after that, the penalty could be lowered to 9%. Make sure to speak to your agent about the surrender charges in your contract.
Bottom line
Variable annuities are mutual fund-type investment contracts wherein the investor pays a specified amount to the annuity company for a specified period to get returns later in life. A variable annuity is based on the performance of the investment products chosen by the investor. Variable annuities, unlike other annuities, offer a higher rate of return but have a greater risk factor. Investors can make the best of the benefits of the raging market by choosing a portfolio that best serves their interests.
Variable annuities must be considered as long-term investments that best serve the investor in retirement. They are not your ideal option if you have short-term financial goals to fulfill. Be wary that there are several additional fees that you will have to pay each year for your investment and you will be fined heavily for early withdrawals. However, if you have invested in variable annuities and think it’s not the best decision for you, you can withdraw your money within 10 days of signing the contract per the ‘free look’ notion.
Seek out a professional financial advisor to figure out which investments suit your risk profile, and ask the advisor if a variable annuity is right for you.
To learn more about the author William Hayslett view his short bio.
Other posts from William Hayslett
