Dear Dr. Don,
What is a variable annuity?
— Jack Jumble
Yours is a simple question with no simple answer. I like to think of variable annuities as an investment in mutual funds packaged inside a life insurance wrapper. The life insurance wrapper provides tax-deferral features as well as some life insurance guarantees.
A variable annuity is a type of annuity contract. It allows the contract owner to select how the annuity is invested by choosing from different investment options. Investment performance influences the annuity’s value. This is in contrast to a fixed annuity contract, where the owner doesn’t have a choice of investments.
The investment options for a variable annuity resemble the choices available when investing in mutual funds. Like mutual funds, the variable annuity owner can invest in funds that hold stocks, bonds and money market instruments.
Fixed and variable annuities may have two phases: an accumulation phase where the investor contributes funds to the annuity, and a payout phase where money is distributed out of the account. (One exception to this is the immediate annuity, which is funded with a lump sum and features annuity payments that begin immediately.)
During the accumulation phase, the investments grow tax-deferred. During the payout phase, the investment earnings distributed out of the annuity are taxed at ordinary income rates. Payouts prior to age 59½ may incur a 10 percent penalty tax.
There are a host of policy options and features that influence the value of the account and the payments out of the account. For a more complete primer on the topic, read the SEC publication “Variable Annuities: What You Should Know” and the Bankrate feature “Are your variable annuities safe?“
Annuity contracts should not be entered into lightly. It’s one area where you want to be completely comfortable with the contract before signing it. Getting a second opinion on a contract is an excellent idea. You could do this by consulting with a fee-only financial planner.
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