What a variable annuity does

A variable annuity is an insurance contract where the amount you receive each month depends on how well the investments inside it perform. Unlike a fixed annuity, which pays you the same amount forever, a variable annuity's payout rises or falls based on the value of the underlying investment accounts you choose.

You give money to an insurance company, which invests it in options you select — typically mutual funds focused on stocks, bonds, or a mix of both. The insurance company guarantees that if you live to a certain age or longer, you will receive income for life. But the size of that income check changes with market performance. If your investments gain value, your payout grows. If they lose value, your payout shrinks.

This is the core trade-off: you get the security of lifetime income, but you accept the risk that some months you may receive less than others.

Key Takeaways

  • Variable annuities let you choose how your money is invested, usually among mutual fund options, and your monthly payout changes based on investment performance.
  • You pay fees for the insurance may provide, the investment management, and often for optional riders that add features like income floors or death benefits.
  • The money you put in grows tax-deferred, meaning you do not pay income tax on gains until you withdraw, but withdrawals before age 59½ may face a 10 percent penalty.
  • Variable annuities are complex products with high costs, and they work best for people with substantial savings who want may provide lifetime income but can tolerate investment risk.
  • You can surrender a variable annuity early, but surrender charges typically explore for the first 5 to 10 years, reducing what you get back.

How the investment portion works

When you buy a variable annuity, you choose from a menu of subaccounts — these are similar to mutual funds but exist only within the annuity. Common options include a stock fund, a bond fund, a money market fund, and balanced funds that mix stocks and bonds. You decide how to split your money among these choices.

Each month or quarter, the value of your subaccounts changes based on market performance. If you chose 60 percent stocks and 40 percent bonds, and stocks rise 5 percent while bonds fall 2 percent, your overall account value will reflect that mix. The insurance company tracks this value and uses it to calculate your income payment.

You can usually change how your money is allocated among subaccounts once or twice per year without penalty, though some contracts allow more frequent changes. This flexibility means you can shift toward safer investments as you age, but it also means you must monitor your choices — the insurance company does not rebalance for you automatically.

How payouts are calculated

The amount you receive depends on three things: your account value, your age when you start taking income, and the annuitization rate the insurance company offers at that time.

Let's say your variable annuity account is worth $300,000 when you turn 70 and decide to start receiving income. The insurance company looks at life expectancy tables and current interest rates, then offers you an annuitization rate — for example, 5 percent per year. Your first payment would be $15,000 per year, or $1,250 per month. But here is the variable part: next year, if your investments have grown to $330,000, your payment might rise to $1,375 per month. If they have fallen to $270,000, your payment might drop to $1,125 per month.

Some variable annuities offer a may provide minimum income benefit (GMIB), which promises that even if your investments perform poorly, you will receive at least a certain minimum payment. This may provide comes at an extra cost, added to your annual fees.

Fees and costs you will encounter

Variable annuities are expensive products, and the costs come in layers. First, there is the mortality and expense risk charge, typically 1 to 1.5 percent per year. This covers the insurance company's cost of guaranteeing your lifetime income and their profit margin. Second, you pay investment management fees on the subaccounts you choose, usually 0.5 to 2 percent per year depending on the fund type. Together, these two charges often total 1.5 to 3 percent annually.

On top of that, if you add optional features called riders — such as a may provide income floor, a death benefit that pays your heirs if you die early, or long-term care coverage — you pay additional annual fees, often 0.5 to 2 percent more. A variable annuity with multiple riders can easily cost 3 to 4 percent per year.

If you withdraw money before the contract's surrender period ends (typically 5 to 10 years), you also pay a surrender charge, which starts high and declines each year. A 7 percent surrender charge in year one might drop to 1 percent by year seven. After the surrender period, you can withdraw without penalty, though you still pay the annual fees.

Tax treatment and withdrawal rules

Money inside a variable annuity grows tax-deferred, meaning you do not owe income tax on investment gains, dividends, or interest until you withdraw. This can be a significant advantage if you have a long time horizon and expect substantial growth.

However, when you do withdraw or start receiving annuity payments, 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 typically face a 10 percent federal penalty on the earnings portion (not on your original contribution). Some exceptions exist — for example, if you are disabled or using the money for certain medical expenses — but these are narrow.

Once you start receiving annuity payments for life, a portion of each payment is considered a return of your original contribution (not taxed) and a portion is considered earnings (taxed). The insurance company calculates this split using IRS tables, and it remains the same throughout your life.

Surrender periods and early withdrawal

Most variable annuities lock your money in for a set period, called the surrender period. During this time, if you withdraw more than a small amount (often 10 percent per year), you pay a surrender charge on the excess. This charge is a percentage of the amount withdrawn, not of your account value, and it decreases each year.

For example, a contract with a 7-year surrender period might charge 7 percent in year one, 6 percent in year two, and so on, reaching zero in year eight. If you withdraw $50,000 in year two and the charge is 6 percent, you lose $3,000 of that withdrawal. The remaining $47,000 goes to you, minus any taxes owed.

After the surrender period ends, you can withdraw any amount without surrender charges, though you still owe taxes on gains and may owe the 10 percent early withdrawal penalty if you are under 59½. Some contracts allow you to withdraw a small percentage each year (often 10 percent) without surrender charges, even during the surrender period.

When a variable annuity might make sense

Variable annuities are most useful for people who have already maxed out other tax-deferred retirement accounts like 401(k)s and IRAs, have substantial savings they want to protect, and want may provide lifetime income but are comfortable with investment risk. They work well if you expect to live a long time and want to may support you do not run out of money.

They are less useful if you need access to your money soon, have limited savings, or prefer straightforward, low-cost investments. The high fees and complexity make them a poor choice for most people with modest retirement savings or short time horizons.

Before buying a variable annuity, compare the total annual costs (all fees combined) to what you would pay in a taxable brokerage account or a simpler fixed annuity. Ask the insurance agent to show you the surrender schedule, the subaccount options, and any riders you are considering. Read the prospectus — the legal document that describes the contract — even though it is dense. The complexity is real, and understanding it before you buy protects you later.

Frequently Asked Questions

Can I change my investment choices after I buy a variable annuity?

Yes, most contracts allow you to move money between subaccounts at least once or twice per year without penalty. Some allow unlimited transfers. Check your contract for any restrictions or fees. Changing your allocation does not trigger surrender charges, but it does not reset the surrender period either.

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

Your beneficiary receives the account value at your death, or a may provide minimum (often your total contributions), whichever is higher. If you added a death benefit rider, it may pay more. The amount is not subject to income tax, though it may be subject to estate tax if your estate is large enough. The exact rules depend on your contract.

Is a variable annuity the same as a fixed annuity?

No. A fixed annuity pays you the same amount every month for life, regardless of market performance. A variable annuity's payment changes based on investment performance. Fixed annuities have lower fees and simpler terms, but offer no growth potential. Variable annuities cost more but let you benefit if investments perform well.

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

Most states require a "free look" period of 10 to 14 days after you buy, during which you can return the contract and get your full money back. After that period, you can withdraw, but surrender charges explore during the surrender period. After the surrender period ends, you can withdraw without surrender charges, though taxes and the early withdrawal penalty may still explore.

Why are variable annuity fees so high?

The fees cover the insurance company's cost of guaranteeing lifetime income, the cost of managing the subaccounts, and their profit. The mortality and expense charge alone reflects the risk the insurance company takes by promising to pay you for life, no matter how long you live. Optional riders add more cost. The total is higher than a straightforward mutual fund, but you are paying for insurance protection, not just investment management.