Variable Annuity Problems

You'll pay more in management fees with a variable annuity.

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A variable annuity is an insurance contract designed to provide a regular source of income. The contractual agreement is between you and the sponsoring insurance company. You purchase your variable annuity, and the company invests your money in your choice of financial vehicles, which might include mutual funds, stocks and bonds. After a set period of time, you begin to receive payments of your initial investment and earnings. This might sound too good to be true, and many financial experts contend variable annuities have a plethora of problems.

Fees and Charges

One of the primary complaints about variable annuities is the operating fees. Forbes reports that fees average at 2 percent, maxing out at 3 to 4 percent annually. SmartMoney contends variable annuity fees are at least 1 percent higher than the average mutual fund fees. Bottom line: You’re going to pay higher fees on a variable annuity than other investment vehicles. You’re also going to pay charges. The Securities and Exchange Commission warns that variable annuities come packed with charges. You’ll have to pay a surrender charge to cash out the annuity early. You’ll also have to pay a mortality and expense risk charge, just to make sure the insurance company is absolved of any risk associated with your annuity. There are also special features -- much like insurance riders -- that you can add on to your variable annuity, but they’ll cost you in extra charges.

Tax Treatment

To rub salt in the higher fee and excess charges wound, the Internal Revenue Service does not bless variable annuities as traditional investment vehicles. Your gains within the annuity will grow tax-deferred, but you cannot take a tax deduction for your initial variable annuity contribution like you can for your traditional IRA contributions. In most cases, variable annuities receive no special tax treatment from the IRS, all gains will be taxed at your normal income tax rate and your heirs do not receive special tax treatment when they inherit your variable annuity upon your death; in other words, they’ll have to pay full taxes on your annuity if you’ve deferred them up to that point.

It’s Not Really Insurance

Although a variable annuity is a contract with an insurance company, it is not really “insurance” in the traditional sense of the word. When investing in a life insurance policy, your heirs receive a predetermined lump sum upon your death, usually tax-free. If you die holding a variable annuity, your heirs will only receive the value of your account -- and be taxed on it to boot. If your variable annuity is in good standing upon your death, this might not be so bad. If the annuity has lost money since your initial investment, your heirs will inherit the loss, unless you purchase a special rider.

Maybe Not So Bad

In some cases, a variable annuity might pay off. If you live long enough to begin receiving your periodic payments, you’ve got extra income coming in monthly. This might work if you’re just looking for a few extra dollars a month to tinker with during your retirement. Overall, however, the variable annuity is not set up to provide you with the long-term investment and tax benefits that other investment vehicles allow, and that just might be the greatest variable annuity problem of all.