Variable annuities are life insurance contracts that provide you with the potential for growth and an eventual income source. Contract terms typically range from five to 10 years, and these annuity products are illiquid, with significant surrender penalties. Like most investments, variable annuities can lose money. However, variable annuity contracts include stipulations that provide you with guaranteed withdrawal benefits.
Within a variable annuity, your actual holdings are invested in mutual fund subaccounts that can gain or lose value over time. Funds are held in mutual funds during the accumulation phase, and this period comes to an end when your contract matures. At that time, your contract annuitizes, which involves the conversion of the money in your account into an income stream. Alternatively, you can withdraw your cash as a lump sum or just roll the money into a new annuity contract.
Your funds are generally inaccessible during the accumulation phase, but some annuity contracts include a clause for annual penalty-free withdrawals. Typically, such withdrawals are limited to 5 or 6 percent of the contract value. Withdrawals from variable annuity contracts are made on a last-in-first-out basis. Since annuities grow tax deferred, this means you gain access to your fully taxable earnings prior to withdrawing your principal, which may or may not be taxable.
Annuity contracts usually include optional contract extras or riders that provide you with guarantees that include minimum withdrawal benefits. A guaranteed minimum income rider assures you of a certain level of return once you convert your contract into an income stream. Essentially, you assure yourself of a return on your investment even if your contract drops in value. A guaranteed withdrawal benefit provides you with a certain sum of money that you can withdraw over the course of, or at the end of, your contract. Regardless of your rider, you always get the greater of your actual account value or the guaranteed level of return.
The death benefit is one of the standard features of a variable annuity contract. You must designate a contract beneficiary, and that individual receives a pre-determined payout in the event that you die before your contract reaches maturity. The death benefit is typically equal to your initial purchase premium, although some firms offer stepped-up benefits that increase the payout. As with living withdrawal benefits, your beneficiaries typically receive the higher of the actual contract value or the guaranteed minimum.
Variable annuity contracts include annual operating expenses that often amount to 1 or 2 percent of the contract value. These fees cover the annuity issuer's administrative costs and the premiums for the death benefit. Optional withdrawal riders add to your costs, because you typically pay an additional annual fee for every withdrawal provision. Lump-sum withdrawals are subject to deductions for rider fees and other contract expenses. Your life expectancy and overall cash flow situation are among the factors you should consider when weighing the pros and cons of buying additional withdrawal benefits.
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