When saving for retirement, it’s common to have overlapping goals. Most of us want to save enough to generate a comfortable monthly income, avoid outliving our savings and leave something for our heirs. A variable annuity is one product marketed at people balancing these objectives. But do the costs outweigh the benefits? Here’s a run-down of the pros and cons of the variable annuity.
What Is a Variable Annuity?
Any annuity has two components, the principal you pay into it and the returns on that principal. Annuities provide income for your retirement on a quarterly, monthly or yearly basis. Generally, you pay into the policy over a period of years before you start receiving payouts. This is called a deferred annuity. However, you can also opt for what’s called an immediate annuity, which requires a big one-time payment from you but then commences regular payouts right away.
A fixed annuity comes with a guaranteed return of a certain (usually low) percentage of your principal. Payouts for variable annuities, on the other hand, aren’t guaranteed. The money you invest in a variable annuity usually goes into mutual funds. These investments, generally a mix of stocks and bonds, could lose money in the market.
In the event that your investments lose money, the insurance company guarantees that you will have access to the money you paid in but no more. So, unlike with normal investments, you’re not at risk of losing the money you paid into a variable annuity. On the other hand, you might not make money.Benefits of a Variable Annuity
Aside from the fact that you’re guaranteed access to your principal, what else does the variable annuity have going for it? For one thing, variable annuities are tax-deferred. This means the money you contribute to a variable annuity can grow without taxation every year. You won’t owe income taxes on that money until you start withdrawing income from your variable annuity.
Variable annuities can come with the option of receiving a fixed monthly or annual payment. This can save you the headache of trying to space out your withdrawals to ensure you have enough to live on.
You can also opt for periodic payments that last for the rest of your life, even if your account loses money because your investments aren’t performing well. Generally, you’ll have to pay extra to set up this option. But you’ll have peace of mind knowing that you have a check coming at regular intervals for as long as you need it. The longer you live, the more you stand to benefit from this option.
Finally, variable annuities offer a death benefit. If you die before you’ve started receiving payments, your chosen beneficiary will receive a payout from the insurance company.Drawbacks of a Variable Annuity
Before you rush out to buy a variable annuity, you should be aware of the drawbacks of this retirement savings vehicle. The biggest potential drawback of a variable annuity is the cost. Variable annuities can charge high fees. These include administrative fees, fees for special features and fund expenses for the mutual funds you invest in.
Finally, there’s the mortality and expense risk charge. This charge, generally around 1.25% of your account value, is charged annually as compensation to the insurance company for taking on the risk of insuring your money. When you add up these fees and charges, variable annuities can be a pricey place to store your money.
In addition to their relatively high cost, variable annuities may not offer tax benefits beyond what you could get with a simpler, more affordable investment vehicle like an index fund. As mentioned above, variable annuities are tax-deferred. But the money you withdraw in retirement is taxable at your regular income tax rate, not the long-term capital gains tax rate. That means you’ll probably owe more in taxes than you would on regular investments you made with after-tax dollars and held for years, because the long-term capital gains tax rate is lower than most income tax rates.
Another strike against the variable annuity is that you can’t deduct the contributions to a variable annuity in the year of your contributions, whereas you can deduct contributions to a traditional IRA.
Furthermore, if you fund a variable annuity with pre-tax dollars through a 401(k), you’re not getting tax benefits beyond what you would get from contributing to any other pre-tax retirement vehicle. You’d probably be better off making the maximum allowable contributions to tax-deferred 401(k) and IRA accounts if you can afford it. If you still have money left over, you might want to consider a variable annuity for further tax deferral, but not instead of a 401(k) or IRA.
Finally, variable annuities often come with a surrender period. This can last for as many as 10 years. If you withdraw your money from the annuity during the surrender period, you’ll have to pay a surrender charge. Generally, the charge is equal to a certain percentage of your withdrawal. Variable annuities usually have surrender charges that decrease with each year you own the annuity, until the charge disappears altogether. With some annuities, however, each contribution you make carries its own surrender period.
The surrender period of variable annuities means that if you need the money for something really important, you won’t just pay income taxes and the federal government’s 10% penalty for early withdrawal from a retirement account. You’ll also pay a surrender charge.How Variable Annuities Stack Up
Variable annuities come with some tax advantages, but they can be expensive. If you’re already saving for retirement in a tax-deferred account like a 401(k) or an IRA, you may not need the benefits a variable annuity offers. But if you’re in the game for one, here’s how they compare to other types of annuities.
The opposite of a variable annuity is a fixed annuity. The main difference between these products is that a fixed annuity doesn’t rely on investments for returns. Instead, the company will offer you a fixed interest rate that it will then apply to your balance. On top of this, fixed annuities typically guarantee the return of your principal. In the end, while fixed annuities are much safer, the returns you could garner from a variable annuity are significantly stronger.
An indexed annuity is very similar to a variable annuity, but it adheres to different investments. More specifically, an indexed annuity will, as the name implies, follow an index. Indexes that usually accompany these annuities include the S&P 500, Russell 2000 and MSCI EAFE. To be clear, the return potential of a variable annuity is traditionally higher than an indexed products. But indexed annuities provide a bit of reliability to concerned investors that might be nervous about getting a variable annuity.Tips for Retirement Planning
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