What is a variable annuity & how does it work?

The bottom line:

Tax-deferred

Earnings are tax-deferred until you begin your retirement income at a future date, usually when you retire.

Investment growth potential

You choose from a variety of subaccounts within your contract, and investment performance is based on market performance.

Retirement income

Like other annuities, a variable annuity could provide ongoing income payments during retirement.

As you approach retirement, your focus may shift from building up a nest egg to ensuring you have ongoing income to cover expenses. A variable annuity is designed to help you accumulate assets for the long-term with the option of converting those savings into a lifetime income stream in retirement.

In this article, we’ll cover:

• What is a variable annuity?
• How does a variable annuity work?
• A living benefit: Guaranteed lifetime withdrawal benefit (GLWB)
• The pros & cons of variable annuities
• How deferred variable annuities put time on your side
• Variable vs fixed annuities: How do they compare?
• When should you consider a variable annuity?
  

A variable annuity is a tax-deferred insurance contract designed for retirement income. The value of a variable annuity fluctuates based on the performance of investment options tied to the market, called subaccounts. Subaccounts often consist of stocks, bonds and money market funds. When you purchase a variable annuity, you decide how to allocate your premiums in the available subaccounts based on factors like your risk tolerance and timeline for retirement.

Any investment earnings from a variable annuity grow tax-deferred until you begin taking withdrawals, or annuity payouts. These annuity payouts can last throughout your life, depending on the payout option you select.

A variable annuity offers several key features: the potential for tax-deferred investment growth based on market performance, the option to elect a guaranteed income stream in retirement, and, depending on the contract, the potential to pass money to your beneficiaries.

• It provides income in retirement. Like other annuities, a variable annuity can provide ongoing income during retirement through withdrawals or the option of guaranteed income payments.

• It offers potential investment growth. Variable annuities let you choose from several investment options, called subaccounts. The growth, or loss, is based on the market performance of the subaccounts selected.

• Any growth is tax-deferred. A variable annuity's earnings are tax-deferred. That means they aren't taxed until withdrawn, which may result in higher growth over time due to compounding earnings. Later, when you take withdrawals or guaranteed payments, that money is subject to income tax.

• Most variable annuities also offer a standard death benefit. A standard death benefit is equal to the premiums you’ve contributed to the annuity, minus any withdrawals you’ve made. This means that if you die when your subaccounts have lost value, your beneficiaries are guaranteed to receive at least the premiums you paid back. Optional death benefits may be available with an additional cost. If you elect guaranteed income payments, any death benefit will depend on the option selected.

In addition to a variable annuity's standard features, you might be able to purchase additional riders that provide more insurance guarantees. This can allow you to customize benefits to suit your particular needs.

For example, a guaranteed lifetime withdrawal benefit (GLWB) rider can allow you to take guaranteed withdrawals for life regardless of market impacts on your contract's value.

• Learn more: What is a GLWB & how does it work?

A variable annuity is designed to provide retirement income. If you have a lump sum of money available, like from a 401(k) or an IRA, consider placing that money into a variable annuity. Or, if you don’t have a lump sum but you would like to make ongoing contributions at your discretion—you could put that money into a variable annuity. That would give you the potential to elect a guaranteed income stream at a date you select in the future that could last the rest of your life.

Your annuity's investment performance will affect how much retirement income you will have each year. You decide how much risk to take on.

• Investing more aggressively could heighten your risk for loss—but also have the potential for higher returns.
• Investing more conservatively might limit your potential loss but generate lower earnings.

Often, it makes sense to base such decisions on how your other retirement savings vehicles are invested. That can help you build a well-balanced portfolio.

• Get more details: Are variable annuities part of your retirement plan?

No financial solution is right for everyone. Recognizing the pros and cons of variable annuities can help you determine if it's right for you.

• Investment growth potential. You can choose subaccounts that suit your risk tolerance. Pursue higher growth potential through more aggressive funds and less risk with more conservative ones.

• Tax-deferred growth. Taxes aren't due until you take withdrawals or begin annuity payouts, which means any earnings have the potential to compound.

• Market-based growth. Variable annuities allow you to select from a range of subaccounts based on your risk tolerance. The performance of those subaccounts may help with long-term inflation, a common risk to your retirement savings.

• Lifetime guaranteed payments. You can supplement your other income sources by electing a guaranteed payment option. This creates a consistent, dependable cash flow.

• Standard death benefit.  Most variable annuities provide a benefit where your beneficiaries are guaranteed to receive your premium. You can choose a contract that may continue to pay out money to your beneficiaries after you pass away.

• It could lose value. It's uncertain how investment subaccounts may perform, so it's impossible to know in advance how much you may earn or lose, and the impact that performance will have on your retirement income. Be mindful of your risk tolerance when you select subaccounts. Some options are more aggressive, and therefore riskier, while others may provide more stable but modest returns.

• They can be complex. Although variable annuities share a basic structure, contract options may vary between insurers. Be sure you understand the terms of your contract.

• Early withdrawal penalties. Variable annuities are meant to be long-term retirement products. Most withdrawals before age 59½ are subject to a 10% federal tax penalty. Additionally, withdrawals before your contract's specified surrender period ends typically trigger surrender charges.

• Fees can add up. Variable annuities typically include higher fees than other investment products, due to their insurance features.

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Need a refresher on the other types of annuities?

There are four basic types of annuities to meet your needs. They are based on two primary factors: when you want to start receiving payments and how you would like your annuity to be invested.

See the types

Variable annuities are deferred, which requires a waiting period between the time you start putting money in and the time you receive its income stream. You can fund a deferred variable annuity with a single premium or a series of payments. Then you choose when to start your withdrawals or annuity payments. This can be around the time you plan to retire, or it can be earlier or later; it's entirely up to you and what suits your situation.

The goal is that you have a long-term time frame to allow earnings to accumulate, but there are no guarantees. Increasing your contract's value can increase the retirement it provides. Many people use deferred variable annuities as part of their overall retirement income plan.

• Read: What is a deferred annuity & how does it work?

An alternative to a variable annuity is a fixed annuity. Variable and fixed annuities differ in the way they grow (or decrease) in value.

• A variable annuity's value rises or falls based on the performance of the subaccounts you select.
• A fixed annuity grows at a predetermined interest rate.

When considering one or the other, some people opt for the riskier variable annuity because it may achieve a higher rate of return. However, if the market trends downward, a variable annuity could earn less than a fixed annuity—or even lose value.

A fixed annuity's set interest rate may only promise a modest return. But it protects against the possibility of market loss and offers the advantage of knowing ahead of time exactly how much the annuity's value can grow.

• Dive deeper: Fixed annuity vs. variable annuity: Understanding the differences

That depends on many factors, including your age, your financial goals, your retirement plans, the resources you have available, the amount of risk you wish to take on and how long you expect to live.

Have you maxed out your allowed traditional IRA or 401(k) contributions? Would you like to put more money away to help support yourself (and spouse) in retirement? If so, a variable annuity may be worth considering. By choosing the subaccounts, you can select a risk tolerance that fits well within your overall financial plan.

Variable annuities let you select from a variety of stock and bond subaccounts with an option to elect a guaranteed income stream in your retirement years. Their complexity carries some costs—but their flexibility allows you to adjust your investment allocations to match your risk tolerance.

Ready to explore whether a variable annuity is right for you? Connect with a Thrivent financial advisor.