Variable Annuities 101

Understanding Variable Annuities
A Variable Annuity contract in the US is defined within the IRS code and is regulated by individual state regulators and by the Securities and Exchange Commission. Annuity contracts can only be issued by life insurance companies. Variable annuities are a contract created by you the individual and an insurance company. The insurer agrees to make periodic payments to you, beginning either immediately or at some future date. You purchase avariable annuity contract by making either a single purchase payment or a series of deposits. Variable annuities have features of both life insurance and investments.

A variable annuity gives an entire host of investment options. The value of your investment as a variable annuity owner will vary depending on the performance of the investment options you choose. The investment options for a variable annuity are typically mutual fund type investments such as stocks, bonds, money market funds, or a combination of the three.
How do variable annuities differ from mutual funds?
Variable annuities differ from mutual funds type investments in three important ways that one should be mindful of:

1) They let you receive periodic payments for the rest of your life (or the life of your spouse or any other person you designate). This feature offers protection against the possibility that, after you retire, you will outlive your assets.

2) They have a death benefit. If you die before the insurer has started making payments to you, your beneficiary is guaranteed to receive a specified amount - typically at least the amount of your purchase payments. Your beneficiary will get a benefit from this feature if, at the time of your death, your account value is less than the guaranteed amount.

3) They are tax-deferred. That means you pay no taxes on the income and investment gains from your annuity until you withdraw your money. You may also transfer your money from one investment option to another within avariable annuity without paying tax at the time of the transfer. When you take your money out of a variable annuity , however, you will be taxed on the earnings at ordinary income tax rates rather than lower capital gains rates. In general, the benefits of tax deferral will outweigh the costs of avariable annuity only if you hold it as a long-term investment to meet retirement and other long-range goals.
How Variable Annuities Work
A variable annuity has two phases: an accumulation phase and a payout phase.
During the accumulation phase, you make purchase payments, which you can allocate to a number of investment options. For example, you could designate 50% of your purchase payments to bonds, 40% to stocks, and 10% to a money market fund. The money you have allocated to each fund investment option will increase or decrease over time, depending on the fund's performance. In addition,variable annuities often allow you to allocate part of your purchase payments to a fixed account. A fixed account, unlike a mutual fund, pays a fixed rate of interest. The insurance company may reset this interest rate periodically, but it will usually provide a guaranteed minimum (e.g., 4% per year).

Example: You purchase a variable annuity with an initial purchase payment of $10,000. You allocate 50% of that purchase payment ($5,000) to a bond fund, and 50% ($5,000) to a stock fund. Over the following year, the stock fund has a 10% return, and the bond fund has a 5% return. At the end of the year, your account has a value of $10,750 ($5,500 in the stock fund and $5,250 in the bond fund), minus fees and charges (discussed below).

Accumulation Phase: In the U.S. Internal Revenue Code the growth of an annuity value during the accumulation phase is tax-deferred and is not subject to current income tax for the annuity's owner. The tax deferred status of deferred annuities has led to their common usage in the United States. Under the U.S. tax code, the benefits from annuity contracts do not always have to be taken in the form of a fixed stream of payments and many of annuity contracts are bought primarily for the tax benefits rather than to receive a fixed stream of income. If an annuity is used in a qualified pension plan or an IRA funding vehicle, then 100% of the annuity payment is taxable as current income upon distribution.

Payout Phase: At the beginning of the payout phase, you may receive your purchase payments plus investment income and gains (if any) as a lump-sum payment, or you may choose to receive them as a stream of payments at regular intervals (generally monthly).

If you choose to receive a stream of payments, you may have a number of choices of how long the payments will last. Under most annuity contracts, you can choose to have your annuity payments last for a period that you set (such as 20 years) or for an indefinite period (such as your lifetime or the lifetime of you and your spouse or other beneficiary). During the payout phase, your annuity contract may permit you to choose between receiving payments that are fixed in amount or payments that vary based on the performance of mutual fundinvestment options.
The amount of each periodic payment will depend, in part, on the time period that you select for receiving payments. Be aware that some annuities do not allow you to withdraw money from your account once you have started receiving regular annuity payments.

In addition, some annuity contracts are structured as immediate annuities, which means that there is no accumulation phase and you will start receiving annuity payments right after you purchase the annuity.

Make sure to conduct proper due diligence when comparing
annuity rates. But the best thing to do is to find a financial advisor to do the research for you and give you the best rate.