How Variable Annuities Work and What They Cost

What a variable annuity is

A variable annuity is an insurance contract where you give money to an insurance company, and in return they promise to pay you income later — but the amount you receive depends on how well the investments inside the contract perform. Unlike a fixed annuity, which pays you a set amount each month, a variable annuity ties your payments to the performance of investment accounts you choose, usually stock and bond funds.

You buy a variable annuity with a lump sum or regular payments during the accumulation phase. The insurance company invests that money in subaccounts — essentially mutual funds within the annuity — that you select. Your account value grows or shrinks based on how those investments perform. When you reach the payout phase, usually at retirement, the insurance company converts your account balance into regular income payments, or you can withdraw money as needed.

Variable annuities are sold by insurance companies and typically purchased through financial advisors or brokers. They are more complex and more expensive than mutual funds or exchange-traded funds that hold the same types of investments.

Key Takeaways

• Your payments from a variable annuity rise or fall based on investment performance, unlike fixed annuities which pay a may provide amount.
• Variable annuities charge multiple layers of fees — mortality and expense risk charges, investment management fees, and often surrender charges if you withdraw early.
• You can choose from subaccounts (investment options) within the annuity, but your choices are limited to what the insurance company offers.
• Variable annuities offer tax-deferred growth, meaning you do not pay income tax on earnings until you withdraw money, but withdrawals before age 59½ may trigger a 10 percent penalty.
• Some variable annuities include riders that may provide a minimum income or protect against market losses, but these add to the cost.

How fees work in a variable annuity

Variable annuities charge fees at multiple levels, and the total cost can be significantly higher than buying mutual funds directly. The mortality and expense risk charge (M&E charge) is an annual fee, typically 0.5 to 1.5 percent of your account value, that covers the insurance company's cost of guaranteeing your income and managing risk. This fee exists because the insurance company is taking on the risk that you will live longer than expected.

On top of the M&E charge, you pay the investment management fees of the subaccounts you choose — these are similar to the expense ratios of mutual funds and typically range from 0.3 to 1 percent per year. Some variable annuities also charge administrative fees, account maintenance fees, or fees for specific riders (add-on features like may provide income or death benefit protection).

Many variable annuities include a surrender charge, a penalty for withdrawing more than a set amount (often 10 percent per year) during the first 5 to 10 years. The surrender charge typically declines each year and eventually disappears. If you withdraw during the surrender period and exceed the free withdrawal amount, you may owe 5 to 10 percent of the amount withdrawn.

Combined, these fees can total 2 to 4 percent per year or more, depending on the contract and the riders you choose. Over decades, this compounds significantly and reduces your net returns compared to lower-cost alternatives.

Tax treatment and withdrawal rules

Variable annuities grow tax-deferred, meaning you do not pay income tax on investment gains, dividends, or interest while the money is in the contract. You only pay tax when you withdraw money. This tax deferral can be valuable if you are in a high tax bracket during your working years and expect to be in a lower bracket in retirement.

When you withdraw money or begin receiving income payments, the portion that represents your original contribution (called your basis) comes out tax-free. The portion that represents investment gains is taxed as ordinary income at your regular tax rate, not at the lower capital gains rate. This is different from mutual funds held outside an annuity, where long-term gains may may have access to for preferential tax treatment.

If you withdraw money before age 59½, the earnings portion is subject to a 10 percent early withdrawal penalty in addition to ordinary income tax. Your original contributions can be withdrawn penalty-free at any time, but determining which portion of a withdrawal is contributions versus earnings can be complex and depends on the contract terms.

Some variable annuities allow you to withdraw a set percentage (often 10 percent) per year without a surrender charge, even during the surrender period. Check your contract for these provisions.

Subaccounts and investment choices

When you own a variable annuity, you direct how your money is invested by choosing from a menu of subaccounts offered by the insurance company. These subaccounts function like mutual funds — they hold stocks, bonds, money market instruments, or a mix — but they exist only within the annuity contract and cannot be bought or sold separately.

The number and type of subaccounts vary by contract. Some annuities offer 20 to 30 options; others offer 50 or more. Common choices include U.S. stock funds, international stock funds, bond funds, money market funds, and balanced funds. Some insurers also offer target-date funds that automatically shift from stocks to bonds as you approach retirement.

You can usually change your allocation among subaccounts without tax consequences, though some contracts limit how often you can make changes. The investment performance of the subaccounts you choose directly determines whether your account value grows or declines, and therefore how much income you receive in retirement.

may provide features and riders

Many variable annuities include or allow you to add riders — optional features that provide guarantees or additional protection. These riders cost extra but appeal to people who want some certainty despite the variable nature of the investment.

A may provide minimum income benefit (GMIB) promises that no matter how poorly your investments perform, you will receive a minimum level of income when you annuitize (convert the contract to regular payments). A may provide minimum accumulation benefit (GMAB) guarantees that your account will grow to at least a certain value by a set date, even if investments lose money. A may provide minimum withdrawal benefit (GMWB) allows you to withdraw a set percentage of your account each year without depleting it, regardless of market performance.

Death benefit riders may provide that if you die before the payout phase begins, your beneficiary will receive at least your original contribution or your current account value, whichever is higher — protecting against the risk that market losses would reduce what your heirs inherit. Some riders also step up the death benefit if the account grows, locking in gains.

Each rider adds to the annual cost. A contract with multiple riders can easily cost 3 to 5 percent per year or more. Before purchasing riders, compare the cost against the actual protection they provide and whether you could achieve similar protection through other means.

Variable annuities versus other retirement savings options

Variable annuities are often compared to 401(k) plans, IRAs, and mutual funds because they all offer tax-deferred growth and invest in stocks and bonds. The key differences center on cost, flexibility, and guarantees.

A 401(k) or IRA holds mutual funds or other investments directly; you own the funds themselves. A variable annuity wraps those same investments in an insurance contract. The insurance wrapper adds the M&E charge and other fees but also provides guarantees (if you purchase riders) and a promise of lifetime income if you annuitize. IRAs and 401(k)s have no built-in income may provide unless you purchase an annuity within them.

Variable annuities have higher fees than buying mutual funds directly through a brokerage account. However, variable annuities offer tax deferral even if you have already maxed out your 401(k) and IRA contributions — there is no annual contribution limit. This makes them useful for high-income earners who want to save more than retirement plan limits allow.

Variable annuities also lock you in with surrender charges, while mutual funds can be sold anytime without penalty. If you need access to your money, the surrender charge can be costly. Mutual funds also offer more favorable tax treatment of gains if held outside a retirement account.

When variable annuities make sense

Variable annuities are most useful for people who want may provide lifetime income in retirement and are willing to pay for that may provide through higher fees. They work best for people with substantial savings who have already maxed out 401(k) and IRA contributions and want additional tax-deferred growth.

They may also fit if you are concerned about outliving your money and want the insurance company to bear that longevity risk. The may provide income riders convert investment risk into income certainty — you trade the possibility of higher returns for the security of a minimum payment.

Variable annuities are generally not the best choice if you want low-cost investing, need frequent access to your money, prefer simplicity, or plan to leave the account to heirs (because of the tax treatment and fees). For most people, a combination of low-cost mutual funds or index funds in a 401(k) or IRA, plus a straightforward fixed annuity or Social Security, provides comparable retirement income at much lower cost.

Frequently Asked Questions

Can I lose money in a variable annuity?

Yes, your account value can decline if the subaccounts you chose perform poorly. However, if you purchase a may provide minimum income rider, the insurance company promises to pay you a minimum income regardless of investment performance — though you may receive less than you would have if investments had done well.

What happens to my variable annuity if I die?

Your beneficiary receives the account value at your death, unless you purchased a death benefit rider that guarantees a higher payout. If you have already begun receiving annuity payments, the terms depend on the payout option you chose — some payments stop at your death, while others continue to your beneficiary for a set period.

Can I withdraw my money whenever I want?

You can withdraw money anytime, but if you are within the surrender period (typically 5 to 10 years), withdrawals above a free amount (often 10 percent per year) trigger a surrender charge. After the surrender period ends, you can withdraw without penalty, though you will owe income tax on any gains.

Is a variable annuity the same as a fixed annuity?

No. A fixed annuity pays you a may provide amount each month, set when you purchase the contract. A variable annuity's payment amount depends on investment performance. Fixed annuities have lower fees but offer no growth potential beyond the may provide rate.

Do I need a financial advisor to buy a variable annuity?

Variable annuities are sold through insurance agents and financial advisors, not directly from insurance companies. Before purchasing, understand all fees, riders, and surrender charges. Consider getting a second opinion from a fee-only financial advisor who does not earn commission on the sale.