When you’re faced with the choice of an annuity, it could be difficult to decide what to go with. It’s tempting to go with a fixed annuity since you’re guaranteed a return, but here why you should consider a variable annuity instead.
What’s a Variable Annuity, Anyway?
A variable annuity is basically a contract between you and an insurance company. Under this contract, the insurer agrees to make periodic payments to you at some future date. You can purchase a variable-annuity contract by making either a single purchase payment or a series of purchase payments.
Annuity contracts have two phases — the savings phase, where you make purchase payments into the contract and the earnings accumulate on a tax-deferred bases, and the payout phase, which occurs when you begin receiving regular payments from the insurance company by electing an annuity income option.
The Free Look Period
You may have heard something called a free look period in relation to variable annuities. These periods allow people to have a period of ten or more days from receipt, during which you can terminate the contract without paying any fees, as well as get back your purchase payments. If you have any questions, like how does a variable annuity work, this would be the best option for you.
Multiple Investment Options
Variable annuities offer a wide range of fixed and variable investment options, each with different objectives and strategies. Keep in mind that the value of your variable annuity will vary depending on the performance of the investment options you choose. Variable-investment options include actively managed portfolios, exchange-traded funds, indexed portfolios, and alternative investments, which include bonds, private placements, and derivatives.
With fixed-investment options, you get a fixed rate of return that’s guaranteed by the insurance company for one or more years. If you withdraw money from a fixed account during the guarantee period, the market-value adjustment may apply.
You can transfer your money from one sub-account to another, or even to a fixed account, without paying current taxes on any earnings you made. If the market conditions change, you may reallocate money among the investment options without worrying about the current taxes.
Earnings from a variable annuity grow on a tax deferred basis. What this means is that income taxes that would have been paid on interest, dividends or capital appreciation are deferred until you make a withdrawal. This means that it’s possible for an investment to grow in an annuity faster than in a taxable investment vehicle with the same rate of return because money that wouldn’t have been used to pay tax on earnings continues to stay invested. If you withdraw your money from a variable annuity, though, you will be taxed on the earnings at ordinary income-tax rates rather than the lower tax rates applicable to capital gains. If you withdraw funds prior to the age of 59 and a half, you may be subject to an additional ten percent tax penalty.
Variable Annuity Fees
In complete contrast with fixed annuities, variable annuities have several fees associated with them.
- Mortality and Expense charge – This is a fee that serves to compensate the insurance company for the various risks it assumes under the annuity contract.
- Administration charges – This covers the costs of mailings and ongoing services. It typically ranges from .10 to .30 percent of the policy value per year.
- Investment Expense Ratio – This fee is a management fee for the sub-accounts in a variable annuity. It can range from .25 to two percent of the value in that account
- Additional Cost of Riders – A rider is an extra feature on your policy that provides you with additional guarantees or death benefits. Depending on the extent of the benefits, it can cost from .25 to 1 percent of the policy value per year.
- Surrender charges – There are multiple policies that pay an upfront commission to the person who sells the policy to you. A surrender charge is put on the variable annuity policy, so if you cancel the policy early, the insurance company can recoup the commission they had to pay out.
The Death Benefit
This is one of the most popular features of the death benefit. If you die, you can select a beneficiary that will receive either the money in your account or a guaranteed minimum, whichever is greater. Some variable annuities let you choose a “stepped-up” death benefit. With this, your guaranteed minimum death benefit could be based on a greater amount than purchase payments minus withdrawal. This feature carries an extra charge with it, which will reduce the value of your account.
There’s a lot more to understand about a variable annuity, such as the fluctuation of the value and lack of a guaranteed return. This only scratches the surface on why you should choose a variable annuity.