How Does a Variable Annuity Work?

by Eric Bank

A variable annuity is an insurance product that pays out an annuity and a death benefit. Your contract with the insurance provider specifies the face amount of the insurance, the minimum premiums and the payout details of the annuity. You may choose to pay premiums periodically or buy a fully paid-up policy through a lump-sum premium. Variable annuities have tax benefits but often saddle customers with high fees.

Annuity

An annuity is a stream of payments over a certain period of time. You first must fund your annuity through cash payments in excess of your insurance premiums. You can purchase investments with your annuity contributions. Frequently, insurance companies offer a selection of mutual funds and money market accounts. The amount of money you receive in annuity payments is variable – it depends on how much money you accumulate in your account. Annuities might make payouts for a fixed number of years, until the cash value of the annuity is exhausted or for the lifetime of the annuitant – the details vary with policy and insurance company.

Life Insurance

Variable annuities are life insurance policies. They differ from term life policies in that they usually offer stable premiums for the lifetime of the policy owner. Frequently, insurance companies offer convertible term policies that allow the owner to exchange part or all of the term policy for a variable annuity without undergoing additional underwriting.

Benefits

A variable annuity shields your investments from taxes until you begin receiving your annuity payments. There are no contribution or income limits on your variable annuity. You might be able to purchase a policy that will make payments for life, even if you outlive your annuity’s accumulated value. Variable annuities permit you to borrow against your accumulated value – you are not obligated to pay back the loan, and the interest you pay is to yourself. Death benefits from most insurance policies are tax-free to the beneficiary.

Drawbacks

Variable annuities can be expensive. You must pay for your life insurance, but in addition you can expect investment and processing charges than can eat into the value of your annuity. You may have to pay surrender charges to terminate your policy. Contributions to variable annuity policies are not tax deductible and you must pay taxes on annuity payments. It might be more economical to purchase a term policy and fund an individual retirement account – your financial adviser can act as a counterpoint to your insurance agent as you decide how to proceed.

About the Author

Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles have appeared in "PC Magazine" and on numerous websites. He holds a B.S. in biology and an M.B.A. from New York University. He also holds an M.S. in finance from DePaul University.

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