Variable annuity: How it works, key risks, and who they’re best for

Saving for retirement is key. It’s an investment in your future and the well-being of your beneficiaries. But how can you be sure you’re investing right?

An annuity typically offers tax-deferred growth and a structured stream of income. Researching the different types of annuities available helps you choose the right contract for your needs.

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As you explore, you’ll encounter many important terms, including qualified accounts, fixed annuities, variable annuities, and life insurance. Each can play a different role in a retirement plan, but variable annuities deserve special attention because they’re tied to market performance.

Here you’ll learn the meaning of a variable annuity, how these investments work, and how they compare to fixed annuities. You’ll also gain practical tools for deciding whether a variable annuity is right for you.

What is a variable annuity?

A variable annuity is a tax-deferred contract offered by an insurance company. It offers investment options through subaccounts that behave like mutual funds and can rise or fall with the market. You earn higher returns when underlying subaccounts perform well, and lower ones when they don’t.

This structure is different from a fixed annuity, which is not market dependent and comes with a fixed interest rate. Investors earn the guaranteed rate even if the market takes a hit.

To mitigate the risks of market volatility in variable deferred annuities, you can purchase an optional account benefit known as a lifetime income rider. This rider guarantees a preset income amount for the rest of your life, even if your variable annuity account balance drops to zero due to performance, not excess withdrawals.

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How does a variable annuity work?

A variable annuity grows tax-deferred and can converts savings into annuity payments during retirement. The contract follows a clear sequence, and each stage affects future withdrawals and tax obligations. Here’s how it works.

Purchase, accumulation, and payout

Holding an annuity involves three main stages:

• Purchase and funding: You enter into the annuity contract with the insurance company and fund the account with either a lump sum or a series of payments.
• Accumulation: The money in your account is invested in the market via subaccounts. Growth depends on market results and underlying subaccount investment options.
• Payout/annuitization: You can receive the invested funds and gains. You can choose to annuitize the account balance, distributing it in a series of equal payments for a specific period or the rest of your life. Or you can choose to make a partial withdrawal and reinvest the remainder of the funds in the account.

Tax deferral

With variable annuities, you aren’t taxed on the investment during the accumulation period — only when you withdraw funds from your account. Funding rules depend on whether you have a qualified or non-qualified account. A qualified annuity receives pre-tax funding, and all withdrawals are taxed as ordinary income. A non-qualified annuity receives post-tax funding, and only the gains are taxed at withdrawal.

Investment choices and subaccounts

The money in a variable annuity is invested in the market through a mix of subaccounts that behave like mutual funds. Each has its own investment strategy, risk level, and management team. You are typically in charge of selecting subaccounts that match your preferences based off what the product offers.

Annuity assets can typically be allocated across a range of stocks and bonds. Some subaccounts follow high-risk, high-reward strategies managed by specialists in this investment type, while other strategies take a lower-risk approach, aiming for stable returns.

The insurance company manages the contract, but you bear all investment risks. The annuity’s growth will fluctuate based on market conditions & subaccounts you select, and, unlike with a fixed annuity, you aren’t guaranteed a certain growth rate. That said, you can move money between subaccounts and adjust your investment strategy as needed to mitigate losses.

Payout structure, withdrawal rules, and taxation

When it comes time to cash out your investment, the following structures, rules, and tax regulations will impact how you receive your funds.

Payout structure

Variable annuities can offer several payout structures:

• Life income (payments until death)
• Period certain (payments for a specific timeframe)
• Life with period certain (combining both features)
• Joint and survivor (continuing payments to your spouse)

Given that these annuities are market dependent and don't have a fixed return rate, no specific payment amount is guaranteed. Only investors who add a lifetime income rider to their annuity receive a guaranteed income.

Withdrawal rules

Variable annuities generally have a surrender period of six to 10 years. During this time, you can’t withdraw funds without paying a surcharge. And even once the surrender period is over, withdrawing from your account before age 59½ can result in a 10% tax penalty from the IRS in qualified annuities.

Tax treatment

Tax treatment on payouts differs for qualified and non-qualified annuity contracts. The IRS treats withdrawals from a qualified annuity as ordinary income, meaning you’re taxed at your regular bracket rate. But if you have a non-qualified annuity, the IRS will only tax gains as ordinary income.

Variable annuity pros and cons

Variable annuities can provide lifelong income once you hit retirement. But before opening an account, it’s wise to consider the following upsides and drawbacks.

Pros of variable annuities

Variable annuities are a unique, potentially beneficial way to save. Here’s why:

• Tax deferral: You don’t pay taxes on your investment during the accumulation period, which can help your money grow faster.
• Lifetime income: A variable annuity can create a steady stream of income in retirement if market performance is strong. A living benefit rider can help ensure you receive guaranteed income when markets decline.

Cons of variable annuities

A variable annuity won’t yield a predictable return or guarantee you lifetime income without a rider. There are also expenses to consider:

• Rider costs: Optional riders add protection but increase the overall cost of the contract.
• Mortality and expense (M&E) fees: The insurer typically charges these fees to cover administrative costs and the risks of providing long-term guarantees.  
• Underlying investment fees: Variable annuities subaccounts operate like mutual funds, so management and transaction fees apply.

Variable annuity vs. fixed annuity

A variable annuity could be the right option, but it’s worth comparing it with a fixed annuity before making your choice. Here’s what to consider.

• Risk: Fixed annuities are a low-risk option because they provide a set rate that doesn’t change with market conditions.
• Growth potential: A variable annuity offers higher potential returns but exposes investors to market risks.
• Fees: Fixed annuities can have lower fees. Variable annuities include management costs and may require a rider to secure guaranteed income.
• Predictability of income: A variable annuity’s returns depend on market results. So future payments can shift over time, making it difficult for investors to estimate potential retirement income. Fixed annuities provide a set rate, which makes retirement income easier to estimate.

What to consider before choosing a variable annuity

A variable annuity is just one possible retirement investing framework. Before deciding whether it’s the best route, think through the following:

• Risk tolerance: The growth potential of variable annuities can be attractive. But if you’re risk-averse, you may prefer a retirement plan that offers fixed returns and a guaranteed future income.
• Time horizon: Both fixed and variable life annuities work best over a long time horizon because they’re designed for retirement. These contracts reward patience and steady growth but aren’t designed for short-term goals. If you need access to funds sooner, consider investment and savings options that offer quicker liquidity.
• Fee sensitivity: Variable annuities often include more costs than a fixed annuity and other retirement products that require less governance and fewer protections. If you’re sensitive to extra costs, you may wish to seek other options.
• Desire for guaranteed income: If having a guaranteed, predictable income in retirement brings you peace of mind, consider a fixed investment or adding a rider to your variable annuity.

Who regulates variable annuities?

While not FDIC-insured, variable annuities are regulated at both the federal and state level. The following measures help investors understand the contract before committing to it:

• State regulations: States set rules for selling annuities, manage agent licensing, and regulate the insurance companies offering these accounts.  
• Federal regulations: FINRA and the Securities and Exchange Commission (SEC) regulate the sale of variable annuities. These entities also review agent licensing and set standards for sales of variable annuities.

Maximize your financial potential with Gainbridge

The smartest retirement investment for you is often a well-researched one. Before seeking uncapped growth with a variable annuity or the security of guaranteed income with a fixed annuity, read up on the pros, cons, and tax rules that shape each option.

Gainbridge offers fixed annuities that provide guaranteed income without market swings. These products come with no hidden costs or fees and can complement a variable annuity by adding stability to your long-term strategy. Explore Gainbridge today to see how an annuity can support predictable, long-term retirement income without market volatility.

This article is intended for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation please contact the appropriate professional. The Gainbridge® digital platform provides informational and educational resources intended only for self-directed purposes. FastBreak™ and SteadyPace™ are issued by Gainbridge Life Insurance Company, a Delaware-domiciled insurance company with its principal office in Zionsville, Indiana and is licensed and authorized to do business in 49 states (all states except New York) and the District of Columbia. Products and/or features may not be available in all states. Guarantees are based on the financial strength and claims paying ability of the issuing insurance company. Please visit gainbridge.com for current rates, full product disclosure and disclaimers and additional information. Withdrawals of taxable amounts are subject to ordinary income tax and if made before age 59½, may be subject to a 10% federal income tax penalty. Distributions of taxable amounts from a nonqualified annuity may also be subject to an additional 3.8% federal tax on net investment income.

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