What is a Variable Annuity?
A variable annuity is a type of contract between you, as an investor, and an insurance company. The Insurer guarantees to make payments to you on specified periodic dates. Depending on the terms of the annuity the payments can begin immediately or sometime in the future. Depending on the terms with the insurance company the annuity is purchased either by a one-time payment or periodic payments.
Variable annuities provide a wide range of options for investing. The total value that the annuity pays out in its lifetime will depend on the performance of the underlying investment options you decide on at the time of purchase. The range of underlying investment options for variable annuities typically include stocks, bonds, money market instruments, or possibly a combination of all three.
The most common underlying instrument of variable annuities is mutual funds. But it is important to note that variable annuities differ from mutual funds in important ways.
- Periodic Payments – You can set up variable annuities to provide you with periodic payments for many years into the future, even the rest of your life. You can also designate another person, like your spouse, to receive payments after you die. This will a guaranteed income for both you and your spouse after you retire and ensure that you will not outlive your assets.
- Death Benefit – Variable annuities have a death benefit included. In case you die before the insurance company has begun disbursing payments you can designate a beneficiary. Your designated beneficiary will receive the benefit of your annuity after your death if your disbursement value is less than the amount guaranteed by the annuity.
- Tax Deferral – Your variable annuity is a tax-deferred investment. This means that no taxes are paid on the income and investment gains portions of your annuity while it remains in the account. You have the ability to transfer your money from within your account from one underlying investment instrument to another without paying taxes at the time of transfer. However, it should be noted that before retirement, your earnings will be taxed at ordinary earnings rates rather than capital gains rates. This makes it ideal for long-term investors. Holding this investment longer will provide you with substantial tax benefits.
How do variable annuities work?
Variable annuities are characterized by 2 phases. The accumulation phase and the payout phase.
In the accumulation phase, the investor will make payments toward the purchase of the annuity. The payments can be used towards a variety of underlying investment options mentioned above. As an example, you could designate 40% of your purchase payments to an international stock fund, 20% to a bond fund, and 40% to a U.S. stock fund. Over time, the percentage you have allocated in each asset type within the investment fund will vary depending on the performance of each. Additionally, you can allocate a portion of your payments to an account that will pay a fixed rate. A fixed account portion can guarantee a minimum return on a portion of your investment to provide a guaranteed income stream. The insurance company may include a clause to periodically change the rate based on market conditions, but it should not be below a minimum rate designated in the contract.
During the accumulation phase, you can move money from one of your investment options within your account to another without paying investment gains tax. But, should you take disbursements from your annuity account during the accumulation phase before you are 59 ½ you could be charged a 10% tax by the federal government.
Once the payout phase begins, depending on what you decide, you can receive your disbursements either as a lump sum or a stream of payments. If you choose to receive a stream of payments, you could set them up monthly for example. These payments can continue for a set period of time, 15 years for example. Or you could enter into an indefinite period until you and your co-beneficiary pass away. During your payout phase, your disbursements can either be fixed or tied to the performance of an index.
1035 Tax-Free Exchange
Under section 1035 of the United States tax code you are allowed to exchange a variable annuity contract you own for another variable annuity contract without paying income and investment gains tax on the variable annuity contract you currently own. 1035 exchanges, as they are known, are very beneficial if you find another annuity that has clauses that you find more in line with your future goals. This means you can change the payout options or widen the selection of underlying investment choices of the variable annuity without a significant loss.
If you have any questions about variable annuities speak to a financial professional or contact us for more information.