Variable Annuities for Dummies

Variable annuities are contracts between an investor and an insurance company. Variable annuities are investment products, not life insurance products. The contract outlines the type of payment or payments the investor will make to the insurance company. These payments are called the premium. The insurance company guarantees the premium will be returned, along with any interest that has been earned, either immediately or at some point in the future.

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Overview

Variable annuities invest in a number of financial instruments, including securities. They are therefore subject to regulation by the Securities and Exchange Commission (SEC). Life insurance agents who offer variable annuities to their clients must be licensed to sell life insurance in the state in which they sell the products. They must also be registered with the National Association of Securities Dealers (NASD). Depending on the types of annuities they sell, they are required to have passed the Series 6 or the Series 7 general securities exams along with all other exams that are required by the state.

The federal and state government regulate variable annuities because an investor is responsible for the risk posed by the investment. When an investor chooses to purchase a variable annuity, he or she incurs the risk of loss. Those interested in investing in variable annuities are therefore always advised to read the prospectus and to make sure their level of risk tolerance matches the investment.

Variable Annuities for Dummies: How Do Variable Annuities Work?

Variable annuities can be established as immediate annuities, but they are more often set up as deferred annuities. Deferred annuities have two phases: An accumulation phase and a distribution phase.

The Accumulation Phase

The accumulation phase can take place over a number of years or even decades. Payments are contributed to the account per the contract. An employer can provide an annuity as part of a defined contribution plan such as a 401(k) plan or 403(b) plan. The money contributed is placed in a special account and then invested per the annuity owner. He or she can normally select from a number of funds ranging from conservative to aggressive. He or she can also choose to invest 100% of the premium in a single fund or divide the premium into different percentages for several funds.

Like all annuities, the earnings on deferred annuities grow tax-deferred. The entire balance of the annuity, the premium and the earnings credited, grow tax-free until the distribution phase begins. Investors can choose to receive distributions before age 59 ½, however, they will incur a 10% federal tax penalty. The insurance company will also probably assess what is called the “surrender charge” if money is distributed from the annuity during the first few years. Surrender charges usually equal a percentage of the amount distributed early and are used to pay an agent’s commission. Surrender charges are usually reduced over time. For example, they might be 7% in the first year, 6% in the second year, 5% in the third year and so on.

A tax-deferred account, especially one that is started early in a career, can accumulate substantial earnings over several decades. Because deductions are not made to pay taxes, the money grows significantly faster. And, a portion of the money contributed to tax-deferred accounts almost always reduces current year tax liabilities.

The Distribution Phase

The owner of a deferred variable annuity “annuitizes” the contract when he or she begins taking distributions. Distributions can be in the form of monthly, quarterly or annual payments. He or she can also choose to receive payments in one lump-sum distribution, or to receive payments for a defined period of time or for life. The length of time he or she chooses for the payouts affect the size of the payouts. For example, if an annuitant wishes to receive payouts for 20 years, they may be higher than if he or she were to choose payouts for life. Lifetime payouts, otherwise known as “guaranteed lifetime income” are determined by the amount of money in the account and the life expectancy of the annuitant.

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Do Variable Annuities Provide a Death Benefit?

Like an insurance product but unlike other financial products, variable annuities do contain a death benefit. An investor can name a beneficiary to receive the premiums that have been paid into the account if he or she dies before payouts begin. The amount given back to the beneficiary in the form of a death benefit will vary by insurance company, but most will usually return at least the premium that has been paid up to the point of the annuity owner’s death.

Annuity owners and beneficiaries are warned, however, that unlike the death benefit paid out on a standard insurance policy, the death benefit paid on a variable annuity will likely be a taxable event, depending on the relationship between the owner and the beneficiary or whether pre-tax or post-tax dollars were used to purchase the variable annuity.

The death benefit, or return of premium, may be subject to both federal and state income and/or capital gains taxes. Once again, investors are always advised to seek the advice of an experienced Certified Financial before investing in and naming a beneficiary on a variable annuity contract.

How Do Variable Annuities Compare to Mutual Funds?

Mutual fund investing can be quite beneficial for experienced investors with the time to research their investments. This can be less expensive than investing in a variable annuity, but it guarantees neither an increase in the size of the account nor income. When the “distribution” phase begins on a mutual fund begins after an investor has retired, the principal in the account can be depleted rapidly. If the required distribution is $3,000 based on the fund owner’s age and the amount of money he or she has saved, it leaves less money in the fund to grow throughout retirement. A retiree runs the risk of draining the account. With a variable annuity, however, a retiree can set up distributions for life, which will eliminate the risk of outliving retirement savings.

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