How Variable Annuities Work and What They Cost

A variable annuity is an insurance contract where your payout depends on how well the investments inside it perform

Unlike a fixed annuity, which pays you a set amount each month for life, a variable annuity lets you choose how the insurance company invests your money. The monthly payment you receive goes up or down based on whether those investments gain or lose value. You bear the investment risk — if the stock funds inside your annuity drop 20 percent, your payment drops too. If they gain 15 percent, your payment rises.

Variable annuities are sold by insurance companies and investment firms. They come with a contract that spells out the investment options available to you, the fees you pay, and the guarantees (if any) the insurance company provides. The contract is often dozens of pages long and uses language that takes real effort to parse.

Most people buy variable annuities through a financial advisor or broker, not directly from the insurance company. That advisor earns a commission on the sale, which is built into the price you pay — you do not see a separate bill, but the cost is there.

Key Takeaways

• Your monthly payment from a variable annuity changes based on investment performance, unlike a fixed annuity where the payment stays the same.
• You choose from a menu of investment options (usually mutual funds) inside the annuity, and you decide how to split your money among them.
• Variable annuities charge multiple layers of fees: mortality and expense charges, investment management fees, and often rider fees for added guarantees.
• The insurance company guarantees to pay you for life once you start withdrawals, but does not may provide the amount will stay level or grow.
• Withdrawals before age 59½ typically trigger a 10 percent tax penalty on top of ordinary income tax, with limited exceptions.

How the investment choices work inside a variable annuity

When you buy a variable annuity, you give the insurance company a lump sum (called the premium). That money goes into a separate account, and you direct how it is divided among the investment options the contract offers. Most contracts offer 10 to 50 different funds — stock funds, bond funds, money market funds, and sometimes target-date funds that shift from stocks to bonds as you age.

You can change how your money is invested once or twice a year, or sometimes more often, depending on the contract terms. The value of your account grows or shrinks with the market. When you reach the age you chose to start receiving payments (called annuitization), the insurance company calculates your monthly payment based on how much money is in your account at that moment, your age, and the payout option you selected.

If your account has grown to $500,000 by the time you annuitize, your payment will be larger than if it has only $300,000. If the market has dropped sharply in the months before you annuitize, your payment will be smaller. This is the core trade-off: you have the chance to earn more, but you also carry the risk of earning less.

The fee structure: what you actually pay

Variable annuities are expensive compared to other investment vehicles. Most charge multiple fees that stack on top of each other:

• Mortality and expense (M&E) risk charge: This is the insurance company's fee for guaranteeing to pay you for life. It typically ranges from 0.5 percent to 1.5 percent of your account value per year. You pay this whether the market goes up or down.
• Investment management fees: The mutual funds inside the annuity charge their own fees, usually 0.5 percent to 2 percent per year depending on the fund. These are separate from the M&E charge.
• Rider fees: If you add guarantees like a may provide minimum income or a death benefit that protects your heirs, you pay extra — often 0.5 percent to 1.5 percent per year for each rider.
• Surrender charges: If you withdraw more than a small amount (usually 10 percent) in the first 5 to 10 years, the insurance company charges a penalty. This can be 5 to 10 percent of the amount withdrawn.

A variable annuity with average fees might cost you 2 to 3 percent per year in total charges. Over 20 years, that compounds significantly. A $100,000 investment growing at 7 percent per year costs you roughly $40,000 to $60,000 in fees by the time you annuitize, depending on the exact fee structure.

Guarantees: what the insurance company actually promises

The core may provide in any variable annuity is straightforward: once you start taking payments, the insurance company will pay you for as long as you live. That payment will not stop if you run out of money in your account. This is valuable if you live into your 90s or beyond, because the insurance company absorbs the longevity risk.

However, the insurance company does not may provide that your payment will stay level or grow. If your investments perform poorly, your payment can drop significantly. Some contracts offer optional riders that add guarantees — for example, a may provide minimum income rider promises that your payment will not fall below a certain floor, even if your investments tank. But you pay extra for this protection, and the may provide has conditions and limits spelled out in the contract.

Death benefits are another common rider. If you die before you start taking payments, a death benefit rider ensures your heirs receive at least what you put in, or sometimes a higher amount. Again, you pay for this protection annually.

Tax treatment and early withdrawal penalties

Money you put into a variable annuity grows tax-deferred — you do not pay income tax on the gains each year like you would with a regular investment account. You only pay tax when you withdraw the money. This tax deferral is one reason people buy annuities.

However, if you withdraw money before age 59½, the IRS typically charges a 10 percent penalty tax on top of ordinary income tax on the earnings portion of the withdrawal. The amount you originally invested (your basis) comes out tax-free, but any gains are taxed and penalized. There are narrow exceptions — disability, a series of substantially equal payments, and a few others — but they have strict rules.

The insurance company also imposes surrender charges if you withdraw too much in the early years. These are separate from the IRS penalty. A typical surrender charge schedule might be 7 percent if you withdraw in year one, 6 percent in year two, stepping down to zero by year eight. This discourages you from cashing out early.

When people buy variable annuities and why

Variable annuities are most common among people in their 50s and 60s who have accumulated savings and want to convert that lump sum into a may provide lifetime income stream. The investment flexibility appeals to people who believe they can pick funds that will outperform the market, or who want to adjust their risk as they age.

Some people buy them inside retirement accounts like IRAs, though this is generally considered inefficient because the tax deferral benefit of the annuity duplicates the tax deferral already built into the IRA. You pay the annuity's fees without getting the main tax advantage.

Financial advisors often recommend variable annuities to clients with large portfolios, partly because the commissions are substantial. A $500,000 annuity sale might generate a $20,000 to $50,000 commission for the advisor, depending on the contract. This creates a conflict of interest — the advisor benefits from the sale regardless of whether it is the best choice for you.

Variable annuities versus other retirement income options

A fixed annuity pays a set amount for life with no investment risk to you. Your payment never changes. This is simpler and cheaper than a variable annuity, but you give up the chance for growth if inflation rises or you want more income later.

A straightforward investment portfolio of stocks and bonds gives you full control and typically lower fees (0.1 to 0.5 percent per year with a low-cost index fund). You do not get a may provide lifetime payment, but you keep your money liquid and can withdraw any amount at any time without surrender charges. You bear longevity risk — you might run out of money — but you also keep any upside if investments perform well.

A deferred income annuity (DIA) is a middle ground. You pay a lump sum now and receive a may provide payment starting at a future date (often age 80 or 85). It costs less than a variable annuity and provides certainty, but offers no investment choice and no flexibility if your circumstances change.

Common mistakes to avoid

One frequent error is buying a variable annuity inside an IRA. Since IRAs already defer taxes, you are paying annuity fees for a benefit you already have. The fees eat into your returns with no tax advantage to show for it.

Another mistake is not reading the contract or asking questions about fees. Many people do not realize they are paying 2 to 3 percent per year in total charges until years into ownership. By then, surrender charges may prevent them from switching without a large penalty.

A third error is annuitizing too early or too late. If you annuitize when you are young and healthy, your monthly payment will be smaller than if you wait until you are older. But if you wait too long and the market drops sharply, your payment will be smaller than it would have been a year earlier. Timing matters, and the contract does not tell you when to annuitize — that is your decision.

Finally, some people buy variable annuities they do not understand because an advisor recommended them. If you cannot explain the fees, the investment options, and the guarantees in plain language, do not sign the contract. Ask the advisor to explain it again, or seek a second opinion from a fee-only financial planner who does not earn commissions.

Frequently Asked Questions

Can I get my money back if I change my mind?

Most variable annuity contracts include a free-look period of 10 to 30 days after purchase. During this window, you can return the contract and get your full premium back with no penalty. After that period ends, surrender charges explore if you withdraw more than the allowed amount (usually 10 percent per year). Read the contract to find the exact free-look period and surrender charge schedule.

What happens to my variable annuity if I die before I start taking payments?

The contract specifies a death benefit. At minimum, your heirs receive the amount you invested. Many contracts may provide they receive the highest account value on any contract anniversary, which can be more. If you purchased a death benefit rider, the may provide may be even higher. The beneficiary receives the payout outside of probate, which can be faster than inheriting other assets.

Can I move my variable annuity to a different insurance company?

Yes, through a process called a 1035 exchange. You transfer the annuity to a new contract without triggering a taxable event. However, you start a new surrender charge period with the new company, and you may lose any guarantees or riders from the old contract. Consult a tax professional before doing a 1035 exchange to understand the full impact.

Is a variable annuity the same as a mutual fund?

No. A mutual fund is an investment only — you own shares and can sell them anytime. A variable annuity is an insurance contract that wraps mutual funds inside it and adds a lifetime income may provide. You pay for the insurance wrapper through the M&E charge. You also cannot access your money as easily, and early withdrawals trigger penalties.

Do I have to annuitize, or can I just withdraw money as I need it?

Most contracts let you choose. You can annuitize and receive a may provide monthly payment for life, or you can take withdrawals on your own schedule. If you take withdrawals without annuitizing, the insurance company does not may provide your money will last for life — you could run out. Some contracts require you to annuitize by a certain age, so check your contract terms.