How Does a Variable Annuity Work?

Retirement benefits offered by employers and the government are subject to income limits that restrict the amount of money you can contribute each year. An annuity is a type of financial product you can buy privately with an insurance company that is not subject to income limits. You can buy an annuity with a single lump-sum payment or a series of payments, which entitles you to recurring income payments during retirement. A variable annuity is a type of annuity where the size of payments you receive varies based on the performance of underlying assets.

Variable Annuity Basics

When you buy an annuity, your contributions go into investments like stocks and mutual funds that can increase in value over time. A variable annuity lets you choose from a selection of investments and the income payments you receive in retirement depend on the growth of the investments you choose. By contrast, fixed annuities pay a specific dollar amount for each periodic payment and does not change over time.

Advantages

The primary advantage of variable annuities is the potential for high investment returns. If you manage to pick investments that perform well, your annuity payments could increase and exceed those that you might receive from a fixed annuity. Annuities also offer tax deferral of investment gains, so you don't pay tax on earnings your account generates until you receive funds during retirement. Investment gains generated by an annuity are taxable as ordinary income when you receive them.

Drawbacks

Since variable annuity payments depend on underlying assets, the value of your annuity can decline if investments don't perform well. Gains on investments you make on your own are generally subject to a maximum tax rate of 15 percent if you hold them longer than a year, but gains distributed from an annuity are taxed at your normal income tax rate, which could be as high as 35 percent. Variable annuities also tend to carry high fees that cut into gains and make it more difficult to come out ahead.

Considerations

It is possible to purchase an annuity with funds from a retirement account like a 401(k) or individual retirement account. Tax advantaged accounts like 401(k)s and IRAs already offer tax deferral, so you don't gain any additional tax benefit by holding an annuity within such an account. In addition, you have to pay income tax on the entire amount of annuity payment if you funded the annuity with pretax or tax deferred money.