What is a Variable Annuity?

by Neal Frankle, CFP ®

what is a variable annuityA variable annuity is a deposit with an insurance company like a regular annuity.  The big difference is that you decide how to invest the money and you have many choices (including growth mutual funds).

As long as you keep your money with the insurance company, you don’t have to pay tax on any growth. This is why it’s called “tax-deferred” growth. But if you make any withdrawals they are fully taxable as income to the extent you’ve had any gains. So if you don’t take withdrawals you can defer the tax for many many years. This is the hook insurance companies use.  Let’s see if variable annuities are all the insurance companies say they are.

How can you invest a variable annuity?

As I said above, a variable annuity allows you to  invest in mutual funds. Each company has a set menu of funds to choose from – and you can only invest in the funds the company offers. Some funds pay interest, others try to provide growth and still others own stocks that pay dividends and will hopefully grow.

Why does everyone want to sell you a variable annuity?

Sales people make huge commissions when they do. I know…I used to sell them. (When I started my career selling investments in a bank, my manager told me to sell more annuities. I didn’t like selling these contraptions so I asked him why he wanted me to do so. He told me that it would help increase my income. It had nothing to do with taking care of the clients. Shortly after that conversation, I quit.)

Commissions range from 6% to 10%. That means if you invest $100,000, the person who sold you the annuity pockets at least $6,000. Guess who pays that $6,000? That’s right…you do. And the commission conversation leads us to……

Why variable annuities stink.

Fees and penalties. The funds inside the annuity have annual costs (usually about 1.5%) and the insurance company has annual administrative costs (usually another 1.5%). There can be a host of additional costs too, but let’s just say that variable annuities charge you at least double what an expensive mutual fund would.  Keep in mind that you pay those charges every year.

Of course, if you are lucky enough to make a profit and withdraw it, make sure you do so after you reach age 59 1/2. If you withdraw profits before reaching that age, you’ll get whacked by the IRS with a 10% penalty.

On top of Uncle Sam’s penalties, you have to worry about the insurance company’s too. They usually penalize you if you don’t hold on to the investment for a fixed number of years. This varies with the contract you sign. I’ve seen some companies charge as much as a 20% penalty if you close the account within 15 years. YIKERS!!!!!

Also, keep in mind that mutual fund growth outside of an annuity can be taxed at the lower capital gains rates.   Within the variable annuity those same gains are taxed at higher rates because they considered income when you withdraw the money.  WHAHHHHH…..

And consider your beneficiaries. If you own mutual funds and die, your beneficiaries may avoid paying any taxes on gains. Under current law, they do this through what is known as a “step-up” in basis. But if you own those same funds in variable annuities, they can’t take advantage of the “step-up” provision. Bummer.

Is there anything good about a variable annuity?

Folks are sometimes attracted to these investments because of the guarantees that are offered.  Often, insurance companies tell investors they guarantee their investment and that the investor can never take out less than they invested. The only problem with these guarantees is that the investor usually has to die in order to get that guarantee. Oh…and by the way…if your contract offers this guarantee you usually have to pay an additional 1.35% every year on top of the fees we’ve already discussed.

There are other fancy-pants bells and whistles. The insurance industry is always coming up with new ways to sell you something. But if there was ever an example of “putting lipstick on a pig,” this is it. That’s why I can’t see many reasons for anyone to ever buy a variable annuity.

What you should do if you already own one of these lemons:

1. Determine costs to get out.

The best option might be to get out of variable annuities completely. Call the company and ask two questions:

  • A – What penalty would the company impose if you closed the account?
  • B – How much has the account grown? Ask this question to determine if you have any tax liability.

2. Should you stay or should you go?

This depends on your age, the gains, your tax liability and other aspects of your particular situation.  But if you do decide it’s best to stay under the umbrella of a variable annuity, you may have the option of rolling it to a different company if your particular provider is too expensive.

Not all variable annuities are alike. Some companies have very low expenses and don’t lock your money up. If you go this route, you’ll have to come up with a strategy of getting the money out of the account without paying huge taxes down the road. I’ll write another post on this issue in the future.

Finally, if you are in the unfortunate situation that the company still imposes a huge charge to close the account, you have to do some calculations.

In this case, consider the cost of staying versus the cost of going. Here’s what I mean. If you stay, you pay ongoing fees as I mentioned above. Let’s say the company charges you 3.5% each year in total fees. Assume they also have a 2% penalty if you withdraw the money now. That means (in this case) the move pays for itself inside of a year. You win!

Of course, you should always talk to your tax and financial advisor before making decisions like this, but I do want to leave you with one last tip. If your tax or financial advisor is the one who sold you this schlock…you might want to consider finding new counsel.

Do you own a variable annuity? What has been your experience? What got you roped into it in the first place?



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{ 11 comments… read them below or add one }

Larry Gittens February 12, 2012 at 8:45 PM

The biggest disadvantage to variable annuities contracts is the treatment of losses. Due to the tax deferred nature of these contracts, there are no capital gains. Gains are treated as ordinary income. It is very difficult to write off losses on variable annuity contracts requiring a knowledgeable CPA.


michael October 20, 2009 at 8:38 PM

ok, here is one for you. feburary of ’06 i finally get started in a 401k. i was pleased as punch to finally be doing something about my retirement. i was so pleased that i didn’t pay any attention to the fact that the company had just changed from a mutual fund 401k to a VA 401k. i just “learned” this last week. Oct 15, 2009. the value of the account is about 22,750.00 i am so disappointed that i have no power to fully control my investing and that i don’t understand the stupid calculus formula that describes what my income will be when i start to “withdraw.” i feel like a big idiot. can’t roll it over until i leave the company. i am considering discontinuation of the automatic payments from payroll and starting a separate IRA. ??? the brochure from the company…happens to be one mr. buffet recently sold his stock from…is very complicated…what happens to fools who mix up 401k plans with VAs?


Neal October 21, 2009 at 4:09 PM

This is maddening.

Not much you can do other than tell your employer to stop playing golf with the insurance agent! That’s often how 401(k)s “offer” VA’s…..I believe it’s completely against the interest of the employees and the only reason firms do it is because of personal relationships.


Neal Frankle August 3, 2009 at 6:16 AM


Without completely discounting the comments of the people who justify VA’s, I take your point.

I don’t agree with the folks who like the VA’s but I still learn a lot from them.

Thanks for taking the time to make your points as well as you did.



Parag August 1, 2009 at 5:16 AM

Thanks for the article. I think what you’ve witnessed here are examples of the venomous repsonse people get from financial advisors ( aka insurance salesmen) when questioned about the utility of VAs. I usually find that when people’s responses are particularly vehement, it usually stems from some deeper underlying insecurity about the matter being criticized.
I’ve had the unfortunate experience of having to rehash my father’s investment portfolio and have found it to be filled with nonsense such as VAs and redundant Whole Life Policies.
He had a smaller annuity with another individual some time ago and most recently had his other traditional IRA rolled over into a new annuity product 3 years ago. Of course I dont have to tell you the incentive for beginning a new annuity contract. It certainly wasn’t for my dad’s benefit.
The surrender charges are now exorbitant. Luckily, as you mention, the taxes are a nonissue due to market performance.. we are now doing the math to figure out the cost/benefit of paying up the surrender charge.
Thanks again for all the work that you are doing and let the punches roll :)
Oh… and if anyone else reads this… pleaseeeee dont let yourself or your loved one get swindles into a VA..Educate yourself , take control, and dont let the fearmongers and the financial institutions/establishment make you believe that you can’t do this ( manage your own money ).. you certainly can.


Neal June 18, 2009 at 7:55 AM


1. I am a licensed individual.
2. Before making libelous remarks, you might want to back them up. What is misleading? Its so easy for someone to say such things…now why don’t you detail what is incorrect rather than making blanket statements.
3. What is incorrect about 10% penalties applying to withdrawals from annuities prior to age 59 1/2?
4. You are right…all annuities stink…not just VA’s. Thanks for pointing that out.


Bob Farmer June 18, 2009 at 7:34 AM

This is arguably the most incomplete and incorrect article on VA’s I have ever read. Obviously not a licensed professional as the author’s mis-statements would result in disciplinary action. I suggest you read the entire tax law and not mislead people with the 10% penalty law. That applies to all tax deferred programs not just VA’s.

Misleading and incorrect information helps no one.


will April 30, 2009 at 5:30 AM

Very misleading article about VAs. First of all, the commissions, for reputable VAs, are similar to Mutual Funds. Most importantly, annuities are the only investment products that can guarantee an income stream you cannot outlive. Bonds, dividends, and systematic withdrawals are all widely susceptible to market risk, and longevity risk.

Lastly, for the most popular guarantees, called living benefits, you do not have to die in order to receive the benefit. Hence the name, living benefits. These benefits guarantee growth, and more importantly, guarantee a stream of income that can go up if the market does well, but won’t go down the if the market does poorly. And, that stream of income is guaranteed for your life, and your spouse’s lifetime.

Are annuities for everyone, no. They are a niche product, and that niche is retirement income. And take are real look at the fees, and compare total expenses of VAs versusus mutual funds, stock portfiolios, adviosry platforms, including trading costs, and you will see that the difference between them all is not so great, but that would require some research, as opposed to spouting off uninformed opinions. If you want to view someone else’s research on the subject, check out North Carolina State Professor John Huggard’s work. He is a securities attorney, as well.


Neal April 30, 2009 at 7:54 AM


Thanks for your comments. With all due respect, VA’s are expensive and the fact that there are mutual funds that are expensive too doesn’t make the VA less so.

The literature I’ve seen on “living benefits” is very confusing and fails to address the real cost of these features. It also fails to compare these features to similar benefits offered by alternative investments (i.e. bonds).


Kirk Kinder April 29, 2009 at 5:15 PM

Great article on VAs. Variable annuities are sold, not bought. These vehicles have very little usefulness.

I think the other big point that you touched on was the tax liability when you withdraw from a VA. With government deficits skyrocketing, you have to believe tax rates will rise, which means many folks will end up pulling their money out and paying a higher tax rate. So much for the tax benefits.


Neal April 29, 2009 at 5:52 PM

Excellent point Kirk. Excellent!


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