Like any other annuity product, a variable annuity is a contract which allows for capital accumulation while remaining in a tax-deferred status. Instead of offering a fixed guarantee and a minimum payment at the payout phase, this insurance product offers the chance to earn higher returns because it invests into bonds and equity sub-accounts. When annuitized for income, the payments vary because the sub-accounts may vary in performance.
The primary benefit of a variable annuity is that it provides an income guarantee for life. It offers a chance for individuals to protect themselves against the possibility of outliving their saved assets. Even if the entire proceeds of the annuity have been exhausted, the contracted lifetime payments will continue if the appropriate riders have come with the policy.
The key disadvantage that is associated with variable annuities is their overall cost. The expenses and fees of this type of policy can be quite high. There are numerous fees that are recurrent as well, such as administrative costs or contract charges. Annuities may also have charges for expense and risk. Some annual costs can be as high as 4%.
Here are some additional variable annuity pros and cons to think about as well.
More Pros of a Variable Annuity
1. You are able to defer taxable income into the future.
The money that you put into a variable annuity can be deferred for taxation purposes into the future. That means if you’ve maxed out your 401k and your IRA contributions, the variable annuity provides another option for investors to create a retirement nest egg for future income. When you hold a variable annuity then you will pay no taxes on the gains in the annuity or its income until you begin to withdraw the money.
2. Variable annuities allow for investments to compound and grow.
The investments made within a variable annuity are allowed to compound and grow without interference. That means there is more money available to grow wealth, which can then be used once you reach the age of maturity or another set date you prefer past the age of 59.5. If you have an emergency, you can still access the money in the annuity as well, albeit with a penalty and taxation on the amount withdrawn.
3. Most variable annuities come with a death benefit.
The structure of a variable annuity allows for the holder of the investment to designate a beneficiary for it. That means if you happen to die before the payout phase of the annuity begins, your beneficiary can still benefit from a guaranteed amount of money. The rules for beneficiaries are a little different than those which apply to the original annuity holder as well, which means the money doesn’t need to be locked up for ages to avoid steep penalties.
4. There are no limits to the contributions.
There is no limit to the amount of money that an individual can place within a variable annuity. That makes it possible to shelter high levels of income from taxation, though there are usually proprietary limits for the initial purchase to prevent abuse of the tax laws that apply to this financial product.
5. Variable annuities are exempt from probate.
Variable annuity contracts are unconditionally exempt from the probate process. That means no one can contest the beneficiary that you name if you choose to have the death benefit rider included on your policy. You can rest assured that your beneficiary will receive their money quickly should something unexpected happen to you.
6. The funds in a variable annuity have protections from creditors.
Although the actual benefits in this category are quite variable, depending upon where you live, most jurisdictions have a mandate that any money placed inside of an annuity contract cannot have an attachment by a creditor. There are some exemptions, however, so be sure to review all possible scenarios with your financial advisor before choosing an annuity if you have a concern in this area.
More Cons of a Variable Annuity
1. There are early withdrawal penalties.
Variable annuities are treated like most other tax-advantaged retirement products. If you withdrawal your money from the annuity before the age of 59.5, then there is a good possibility that you’ll be charged a 10% penalty on the funds that you take out. Since most annuities have a minimum deposit of $100,000, that means the penalty could be as high as $10,000. On a $250,000 early withdrawal, the penalty would be $25,000.
2. There are smaller fees on other investment-type products.
Variable annuities will typically have an annual administrative fee that is in the 2%-2.5% range. In comparison, exchange-traded funds that use a broad market may have annual feels as low as 0.25%. Mutual-fund bonds usually have an administrative cost that hovers around 1%, as do large-cap stock funds. Even small-cap and international funds have lower administrative costs, on average, when compared to variable annuities.
3. Withdrawals are taxed at your ordinary income rate.
Instead of using the long-term capital gains tax rate, like some investment products, a variable annuity uses your ordinary income rate for taxation when you make authorized withdrawals. There are two pitfalls here. If your variable annuity experiences a large value increase, then your personal tax bracket may be near the top instead of near the bottom. Your earned income will also affect your final tax bracket, so high-income earners will pay a higher tax on their annuity withdrawal.
4. Variable annuities have a poor cost basis.
If your annuity is given to a beneficiary, then they will be forced to pay taxes on the entire contract value that has grown from the time you initially purchased this financial product. The cost basis does not step up when a variable annuity is inherited, unlike other securities and stocks.
5. It is a very complex financial product.
A variable annuity is one of the most complex financial products that are available right now. These instruments are often marketed in a way that creates confusion. Even those who sell this product do not always fully understand what the variable annuity can do. For that reason, it is important to fully understand all of the financial benefits and consequences that are unique to your situation before making the decision to invest.
These variable annuity pros and cons show a financial instrument that may be right for high-income earners and individuals who are seeking out a guaranteed income later in life. Like any financial product, there are certain risks, fees, and associated costs that must be carefully considered before making an investment. If handled properly, a variable annuity can be an amazing tool that can stabilize your financial future or that of your chosen beneficiary.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.