How Variable Annuities Work and What They Cost

What a variable annuity is

A variable annuity is a contract between you and an insurance company where you give them money now, and 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 regardless of market conditions, a variable annuity ties your payments to the performance of investment accounts you choose.

You control how your money is invested by selecting from a menu of investment options — usually mutual fund-like portfolios that hold stocks, bonds, or a mix of both. If those investments grow, your annuity value grows with them. If they decline, your annuity value declines too. This means your future income is not may provide; it fluctuates based on market performance and your investment choices.

Variable annuities are sold by insurance companies and typically come with a long list of fees and features that make them more complex than other retirement savings accounts. Understanding what you pay for and what you actually receive is essential before committing money to one.

Key Takeaways

• Variable annuities let you choose how your money is invested, so your future payments depend on investment performance rather than being locked in at a set rate.
• You pay multiple layers of fees: investment management fees, insurance charges, and often surrender charges if you withdraw money early.
• Variable annuities are designed for long-term holding; withdrawing money in the first 5 to 10 years typically triggers a surrender charge that can be 5 to 10 percent of your withdrawal.
• The insurance company guarantees to convert your account value into income payments at a future date, but the payment amount is not may provide unless you buy an optional rider.
• Variable annuities are not tax-advantaged retirement accounts like IRAs or 401(k)s; they are insurance products that offer tax deferral on investment gains.

How investment choices work inside a variable annuity

When you open a variable annuity, the insurance company gives you a list of investment options called subaccounts. These are similar to mutual funds but are managed specifically for the annuity. You decide how to split your money among them — for example, 60 percent in a stock subaccount, 30 percent in a bond subaccount, and 10 percent in a money market subaccount.

Your choice matters because it directly affects your account value and the income you eventually receive. If you choose aggressive stock-heavy subaccounts and the market rises, your account grows faster. If the market falls, your account shrinks. You can usually change your allocation once or twice per year without penalty, though some contracts allow more frequent changes.

The insurance company does not manage these investments for you — you are responsible for deciding which subaccounts to use and monitoring them over time. This is different from a fixed annuity, where the insurance company manages the money and guarantees a return.

The fee structure: what you actually pay

Variable annuities carry multiple overlapping fees that can significantly reduce your returns. Understanding each layer is crucial because the total cost is often not obvious from the sales materials.

Mortality and expense risk charge (M&E): This is the insurance company's fee for taking on the risk of paying you income for life. It typically ranges from 0.75 to 1.50 percent per year of your account value. This fee is deducted automatically and is separate from what you pay the investment managers.

Investment management fees: Each subaccount charges a fee to manage the investments within it, usually 0.25 to 1.00 percent per year. These fees vary by subaccount and are deducted from that subaccount's performance.

Administrative fees: The insurance company may charge an annual administrative fee of $25 to $100 or more to cover record-keeping and customer service costs.

Surrender charges: If you withdraw money beyond a small annual allowance (often 10 percent) during the surrender period — typically 5 to 10 years from purchase — you pay a surrender charge. This charge starts high (sometimes 7 to 10 percent of the withdrawal amount) and declines each year until the surrender period ends. After that, you can withdraw your money without this penalty.

Rider fees: Optional add-ons like may provide income riders or death benefit riders cost extra, usually 0.25 to 1.50 percent per year. These riders modify what the insurance company promises to pay you.

may provide income riders and what they cost

A basic variable annuity does not may provide how much income you will receive — only that you will receive income for life based on your account value at the time you start withdrawals. If your investments perform poorly, your income will be lower. To add a may provide, you must purchase a rider, which is an optional add-on to the contract.

Common riders include a may provide minimum income benefit (GMIB), which promises a minimum income payment even if your account value has declined, and a may provide lifetime withdrawal benefit (GLWB), which lets you withdraw a set percentage of your account value each year for life, regardless of market performance. These riders cost 0.5 to 1.5 percent per year in additional fees.

The trade-off is clear: you pay more in fees to get a may provide. Whether that may provide is worth the cost depends on your situation, your risk tolerance, and what you could earn in other accounts. A financial professional who is not selling the annuity can help you compare the cost of the rider to the value of the may provide.

Surrender periods and early withdrawal penalties

Variable annuities are designed to be held for a long time. If you need to withdraw money before the surrender period ends, the insurance company charges a surrender charge as a percentage of the amount you withdraw. This charge is in addition to any taxes or penalties you might owe.

The surrender period typically lasts 5 to 10 years, though some contracts extend to 15 years. During this time, you can usually withdraw up to 10 percent of your account value each year without a surrender charge. Any withdrawal beyond that 10 percent triggers the penalty on the excess amount.

For example, if your contract has a 7-year surrender period and a surrender charge that starts at 7 percent, and you withdraw $50,000 in year 3 when your account value is $200,000, you would owe a 7 percent surrender charge on the $50,000 withdrawal — $3,500. After year 7, the surrender charge disappears, and you can withdraw any amount without this penalty (though you may still owe income taxes on the gains).

Tax treatment and when you pay taxes

Variable annuities offer tax deferral, meaning you do not pay income tax on investment gains while the money is in the contract. Taxes are due only when you withdraw money or start receiving income payments. This is different from a taxable brokerage account, where you pay taxes on gains and dividends each year.

However, tax deferral is not unique to variable annuities. Traditional IRAs and 401(k)s also offer tax deferral, and they come with much lower fees. The tax deferral benefit of a variable annuity is often overstated in sales presentations because the high fees can offset any tax savings.

When you do withdraw money or take income, the gains are taxed as ordinary income at your regular tax rate, not at the lower capital gains rate. If you withdraw before age 59½, you may also owe a 10 percent early withdrawal penalty on the gains portion (not the principal you contributed). This penalty is separate from any surrender charge.

Variable annuities versus other retirement accounts

Feature	Variable Annuity	Traditional IRA	401(k)	Taxable Brokerage
Tax deferral on gains	Yes	Yes	Yes	No
Annual contribution limit	None	$7,000 (2024, age under 50)	$23,500 (2024, age under 50)	None
Typical annual fees	1.5% to 3%+	0.03% to 0.50%	0.10% to 0.75%	0.03% to 0.50%
Surrender charges	Yes, typically 5–10 years	No	No	No
may provide income option	Yes, with rider (extra cost)	No	No	No
Access to money before retirement	Possible but expensive	10% penalty before 59½	10% penalty before 59½	No penalty

Variable annuities are often compared to IRAs and 401(k)s because all three offer tax deferral. The key differences are contribution limits, fees, and flexibility. IRAs and 401(k)s have annual contribution limits but much lower fees. Variable annuities have no contribution limit but charge significantly more in fees and restrict access to your money through surrender charges.

If you have already maxed out your IRA and 401(k) contributions and want additional tax-deferred growth, a variable annuity might be worth considering — but only after comparing the fees to other options. A taxable brokerage account with low-cost index funds may serve you better, depending on your tax situation and time horizon.

Frequently Asked Questions

Can I lose money in a variable annuity?

Yes. Your account value rises and falls with the performance of the subaccounts you choose. If the stock market declines and you have invested heavily in stock subaccounts, your account value will decline. You could withdraw less than you put in if you withdraw during a market downturn. However, if you purchase a may provide income rider, the insurance company promises a minimum income payment regardless of account performance — but you pay extra fees for that may provide.

What happens to my variable annuity if I die?

Most variable annuities include a death benefit that pays your beneficiary the greater of your account value or the amount you contributed, even if the account has declined. Some contracts offer enhanced death benefits for an additional fee. After your death, your beneficiary receives the payout and the contract ends. The death benefit is one reason variable annuities charge a mortality and expense fee.

Can I withdraw my money early without a penalty?

You can usually withdraw up to 10 percent of your account value each year during the surrender period without a surrender charge. Any withdrawal beyond that 10 percent triggers the surrender charge, which can be 5 to 10 percent of the excess amount in the early years. After the surrender period ends (typically 5 to 10 years), you can withdraw any amount without a surrender charge, though you will owe income taxes on the gains.

Is a variable annuity the same as a fixed annuity?

No. A fixed annuity pays you a may provide income amount that does not change, set by the insurance company when you purchase the contract. A variable annuity's income depends on how your chosen investments perform. Fixed annuities have lower fees and more predictable income but offer no growth potential if markets rise. Variable annuities offer growth potential but carry higher fees and income uncertainty.

Do I need a variable annuity if I have a 401(k)?

Not necessarily. A 401(k) offers tax deferral with much lower fees and no surrender charges. If you have not maxed out your 401(k) contribution limit, that is usually a better place to save. Variable annuities make more sense only if you have already contributed the maximum to your 401(k) and IRA and want additional tax-deferred growth with a may provide income option.