A variable annuity is a type of investment account that allows account contributions to be invested in mutual funds. Because of this, the balance of the account can rise and fall based on investment performance, and after some time, the money is used to provide a series of periodic annuity payments for the account holder's lifetime.

What is a variable annuity?

A variable annuity is a tax-deferred investment product that allocates your money to mutual funds that you select, much like a 401(k). Your contributions will grow (or decline) based on the performance of the investment funds you select, and your profits aren't taxed until you take the money out of the account.

Also like a 401(k), the investment funds available to holders of variable annuities invest in stocks, bonds, or money market instruments, or a combination of these things.

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Unlike a 401(k), a variable annuity allows you to receive monthly income payments that are guaranteed for the rest of your life, which makes them a popular choice for people afraid of running out of money in retirement. Variable annuities also have a death benefit, meaning that your beneficiaries are guaranteed to get a certain minimum amount of money -- typically the amount of your contributions, if the annuity hasn't started making payments yet, no matter how much money is in the account.

Accumulation and payout phases

Variable annuities work in two phases -- accumulation and payout. The accumulation phase is when you contribute money and allocate it to the investment funds of your choice. During this phase, you can typically transfer money from one investment option to another, just like with your 401(k), and your account balance will rise and fall with your investments' performance.

During the payout phase, you can withdraw all of the money from your account as a lump sum, but the most common withdrawal method is a series of monthly payments that lasts for you and your spouse's entire lives.

Tax benefits and other advantages

Perhaps the top advantage of investing in a variable annuity is tax-deferred investment growth. Once you contribute money to a variable annuity, any earnings are tax-deferred until you start to withdraw from the account.

In addition, there are other benefits:

  • Lifetime income -- Once you choose to start receiving monthly payments from your variable annuity, it is guaranteed for the rest of your life. You can even set it up so your spouse gets a guaranteed payment for the rest of his or her life.
  • Sheltered from creditors -- Generally, creditors and other collectors cannot go after annuities.
  • Potential for investment gains -- Just like investing in stocks, bonds, or mutual funds, your money has potential to grow exponentially over time.

Potential disadvantages and things you should know

Annuities have received some bad publicity over deceptive sales techniques and high commissions that aren't properly disclosed to investors. While there are indeed some good variable annuity products out there (commission free, reasonable investment expenses), this is certainly something to be aware of. It's not uncommon for an agent to make a commission of 5% or so on the sale of an annuity.

In addition, the tax advantages of an IRA or 401(k) are generally better, as you get the double benefit of deducting your contributions from current income and tax-deferred investment growth. Even the Securities and Exchange Commission (SEC) advises most investors to max out these accounts first.

From the SEC's website:

"For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity. In addition, if you are investing in a variable annuity through a tax-advantaged retirement plan (such as a 401(k) plan or IRA), you will get no additional tax advantage from the variable annuity."

In addition, there are some other potential drawbacks you need to know about:

  • Once the contract is annuitized, meaning that you agree on a monthly payment amount, your decision is final.
  • You can't touch the money in a variable annuity until you are 59-1/2 years old, unless you want to pay a 10% IRS penalty.
  • Some annuities charge a surrender fee, which kicks in if you exchange your annuity to another company within a pre-set amount of time. Generally, this is initially a high percentage (such as 7% of your account), and declines over a period of a few years.
  • Some annuities also have high fees. The average annuity has expenses of about 1.4%, meaning that 1.4% of your total assets will go to fees and expenses every year. It's not uncommon for this to be much higher -- say 2.5% or so. Make sure you know how your fees compare before investing.

Is a variable annuity right for you?

A variable annuity can be a smart choice for tax-deferred retirement income if you have already maxed out your contributions to other tax-deferred accounts such as an IRA or 401(k), and the variable annuity you're looking at has reasonable fees, no big sales commissions, and good investment options.

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