How a Variable Annuity Can Boost Tax-Deferred Retirement Savings
If you’re looking for a way to add to your tax-advantaged investments – even if you have “maxed out” other qualified savings options like a traditional IRA and 401(k) – a variable annuity could be a good solution for you.
That’s because variable annuities offer a wide range of investment options that are allowed to grow on a tax-deferred basis, and can also allow you to continue growing your portfolio, with no maximum annual contribution limits.
Variable annuities also have additional benefits, too, such as the option to receive an ongoing stream of income in the future, and a death benefit that is paid out to loved ones so you can leave a legacy.
What is a Variable Annuity?
As with other types of annuities, a variable annuity is a contract between you and an insurance carrier. Depending on the annuity, you may contribute a single lump sum, or alternatively multiple contributions over time.
All variable annuities can differ with regard to the investment options they offer, but typically, these will consist of mutual funds. With a variable annuity, your funds are not invested directly into the equities, though, but rather in “sub-accounts” at the insurance company.
Based on the underlying investments you have chosen – as well as market performance - the value of your variable annuity’s account can fluctuate over time. So, while your account may grow significantly, there is also risk of loss involved.
Variable annuity benefits can include:
- The opportunity for a higher return (as compared to fixed and fixed indexed annuities)
- Tax-deferred growth (meaning there is no tax due on gains, until the time of withdrawal)
- The ability to generate an ongoing income.
- A death benefit that is paid to a named beneficiary (or multiple beneficiaries)
- A method of adding to your tax-advantaged savings, even if you have already maxed out other qualified savings options
How Do Variable Annuities Work?
Variable annuities have two distinct “phases.” These are the accumulation phase and the payout (or “annuitization”) phase. During the accumulation phase of the variable annuity, you can make premium contributions and decide which investment to track from a menu of options.
These types of annuities also offer a fixed account so that you can allocate a portion of your funds there to help with diversification. The fixed account pays a set rate of interest that is set by the insurance carrier. This rate, however, may change over time (although there is usually a guaranteed minimum amount).
During the accumulation phase of a variable annuity, you are also typically allowed to transfer funds from one of the investment options to another, without having to pay tax. This can allow you to reallocate funds, based on your changing needs and/or account performance.
Some variable annuities do not have an accumulation phase. These are known as immediate annuities. With an immediate variable annuity, you typically make a lump sum contribution (such as a rollover from an IRA or 401k plan), and income will begin right away (or within 12 months after purchasing the annuity).
The payout phase of a deferred variable annuity (i.e., an annuity that you have paid into for some time) starts when (or if) you opt to start taking an income from it. There are usually a number of income payout options to choose from with immediate variable annuities.
These may include receiving income for a set number of years (such as 10 or 20), or even an income that continues to pay out for the remainder of your lifetime, regardless of how long that may be.
Variable annuities may offer other features and benefits, too. For instance, there may be a variable annuity death benefit that could be paid out to loved ones if the annuitant (the income recipient) passes away before he or she receives all of their income.
Unlike a life insurance death benefit, though, annuity death benefits are not income-tax free. Your beneficiary can usually choose to take the death benefit as one single lump sum, or alternatively as a series of payments over time.
Some variable annuities may also offer living benefits. These can provide various guarantees, such as safety of principal, or a minimum amount of income that is provided to the annuitant. For example, a Guaranteed Minimum Accumulation Benefit, or GMAB, will guarantee that the value of the annuity won’t fall below the amount of the initial investment – regardless of market performance.
The Guaranteed Minimum Withdrawal Benefit (GMWB) can provide a guarantee that the annuitant will receive a set amount of money via withdrawals. For instance, with this feature, you will receive no less (over time) than the amount of money you contributed to the annuity. (If you pass away before receiving this amount, though, the remainder will go to your named beneficiary).
Likewise, the Guaranteed Minimum Income Benefit, or GMIB, provides you with a minimum rate of return on your principal in the variable annuity (no matter how the market actually performs).
There is often an additional amount of premium required to add any of these optional benefits to a variable annuity. The different “bells and whistles” that are associated with variable annuities can also be somewhat confusing – even for well-educated investors. Also, variable annuity rates can also differ from one option to another.
With that in mind, it is important that you first take a look at all of your potential options with an annuity specialist. Otherwise, you may find that you’ve made a long-term commitment on a financial vehicle that won’t perform the way you anticipated it to.
Because variable annuities are considered securities (due to their investment feature), you must also receive a prospectus prior to purchasing one. In addition, the financial advisor who sells variable annuities is required to hold specific industry licenses.
For people concerned about paying too much in fees with their variable annuity, we do offer a complimentary fee analysis service which involves our team thoroughly reviewing your prospectus and helping you calculate how much you are paying in fees.
Types of Variable Annuities
Similar to fixed and indexed annuities, not all variable annuities are exactly the same. In fact, these annuities can vary quite a bit from one to another.
For instance, a variable annuity may be immediate or deferred. With an immediate variable annuity, income will begin right away. This type of variable annuity may be right for someone who is retiring soon (within the next 12 months) and wants to set up an income stream to replace their paycheck.
Deferred variable annuities may be a good option for someone who is not planning to retire for many years, and who also wants to take advantage of market-related growth on a tax-deferred basis. In this case, however, it is important to keep in mind that variable annuities can also be subject to risk if the market – and in particular, the underlying investments – perform poorly.
A variable annuity can also be qualified or non-qualified. With a qualified variable annuity, your contributions typically go into the annuity pre-tax. The growth takes place tax-deferred, too, so at the time of withdrawal, 100% of the funds you receive will be taxable.
On the other hand, a non-qualified annuity will contain contributions that have already been subject to income tax. In this case, because the growth inside of the account is tax-deferred, a portion of each income payment or withdrawal will be subject to tax, and a portion (i.e., the amount that is considered a return of your contribution) will be received tax-free.
Variable Annuity Pros and Cons
All financial tools have various pros and cons. The same holds true for annuities. One of the primary benefits that a variable annuity offers is guarantees. By definition, a variable annuity is considered an insurance product – and because of that, these annuities are required to provide at least some guarantees to their holders.
In this case, the contract must ensure that your initial investment will be paid out. This can be done through income payments and / or a death benefit that is paid out to a beneficiary if you pass away and have not yet received all of your money back.
If you’re looking for a way to supplement your income in retirement, variable annuities can offer a benefit, as well, by paying out an income stream for a set amount of time, or even for the remainder of your lifetime. This can help to alleviate the worry about running out of money in retirement.
Variable annuity returns can also be higher than those of a fixed annuity. Because variable annuities track various market investments like mutual funds, you have the opportunity to generate a much higher return than a fixed account that is only set at 2% or 3%.
But the opposite is also true. Because of their link to market performance, variable annuities come with some added risk. So, if your annuity’s underlying investments have a down year (or worse yet, multiple down years), there is the potential for negative returns.
While there is market-related risk involved with these annuities, there are still some variable annuity guarantees that you can count on. With some variable annuities, for example, you can purchase added protection. But this will usually cost you through the payment of additional premium.
In addition, variable annuity fees can also cut into your return. Depending on the particular variable annuity, these fees can include:
- Mortality & Expense (M&E) charges
- Administrative fees
- Contract fees
- Distribution charges
Keep in mind that variable annuity fees are not just based on the annuity itself, but can also be garnered from each of the individual investment options you have chosen. Altogether, variable annuity fees can often cut into 2% or more of your annual return.
Variable Annuity vs Fixed Annuity
Based on your short- and long-term financial goals, you may be wondering whether a variable annuity or a fixed annuity will be best for you. It can help to compare each type of annuity in order to determine which most closely fits.
Some of the primary variable annuity features include:
- Market-related growth opportunity
- Some guarantees
- Death benefit
- Ongoing income
- Living benefit options
But keep in mind that there is market-related risk with variable annuities. These annuities are also known for their fees – which can actually add to any losses that are incurred in “down” years.
With a fixed annuity, there are a number of benefits – particularly in terms of safety, predictability, and guarantees, such as:
- Principal protection in any type of market environment
- Set interest rate
- Tax-deferred growth
- Guaranteed income – with the option of lifetime income for as long as you may need it
There are some downsides with fixed annuities, too, such as low returns that may not be able to meet, much less beat, inflation. This, in turn, can lead to a loss of future purchasing power.
Both fixed and variable annuities may allow for at least some liquidity. So, you may be allowed to withdraw up to 10% of the contract value, even in the early years of the annuity. However, because most annuities impose surrender charges, it is likely that if you take out more than 10% during the surrender period, you will have to pay a withdrawal fee. (Surrender charges usually start out at a higher percentage – in some cases, in the double digits – and then gradually grade down over time until they reach 0%).
Another important item for you to keep in mind is that if you make withdrawals from an annuity before you reach age 59 ½, you could also incur an additional 10% “early withdrawal” penalty from the IRS.
In any case, all annuities should be considered as a long-term financial commitment, so it is important that you have a good understanding of how these products work, and how they may or may not work for you and your specific objectives. Walking through your annuity options with someone who specializes in this field can be a great way to become educated on what you can expect going forward.
Who Should Buy Variable Annuities?
Before you purchase a variable annuity, it is essential that you know what you can anticipate in terms of performance and projected return, as well as any of the risks that may be involved. So, while there are a number of nice benefits that can be received with variable annuities, it is recommended that you first discuss all of the pros and cons with an annuity specialist. If you are unsure if a variable annuity is right for you, feel free to take our 30 second online annuity quiz, which can show you what type of annuity may be suitable for your retirement.
At Annuity Gator, our mission is to educate consumers on all things annuity. We are a team of annuity and retirement income experts, and we can help you to compare your options and narrow down which – if any – annuity is right for you.
Feel free to contact us directly by phone at (888) 440-2468 and chat with one of our annuity specialists. We can also be reached by email through our secure online contact form here so you can schedule a convenient time to talk.