Variable Annuities

What is a Variable Annuity Plan?


A variable annuity is basically marketed as an insurance contract which will provide minimum monthly retirement benefits.  Before you get involved with a variable annuity, you should do your due diligence and ask a bunch of questions.  This article is going to cover the pro's and con's of a variable annuity plan.  Too many times, insurance sales agents will give only half the truth to prospective buyers of these plans.

Be definition, a variable annuity is a contractual agreement between the annuity holder and the insurance company which stipulates that annuity holder will received a fixed periodic payment beginning immediately or at some point in the future.  The "variable" portion of the annuity exists due investments that are made with your cash contributions.  Investments options include stocks, bonds, or money market instruments that you will be able to mix and match. 

Variable Annuities vs Mutual Funds


There are three key differences that you should be aware of between investing in a regular mutual fund and funding a variable annuity.  The first and most popular feature of the variable annuity is that it allows you to receive periodic payments for the remainder of your life.  Many who fear that they will eventually run out of money if they live for too long gravitate to a variable annuity to guarantee their cash flow remains constant.

Secondly, similar to a Roth IRA, contributions grow tax-free until you withdraw them at retirement.  However, at retirement, your withdrawals will be taxed at your ordinary income tax rate.  Proponents of a variable annuity suggest that this benefit will offset the fees that are charged on the backend to participate in such a plan.  This only holds true if you keep this plan active for the long term.

Finally, there is a death benefit associated to the variable annuity.  In the event that you die before periodic payments are made to you and the value of your account is less than the guaranteed amount, your beneficiary will be eligible for for at least the amount of your purchase payments.

One key point to understand here is that you will not be able to take advantage of the tax-deferral within a variable annuity if you participate in another plan which provides tax advantages.


How does a Variable Annuity Work?


Variable annuities have what is called an accumulation phase, which is the period of time in which the investor will build up the cash value portion of the annuity.  Obviously, the more you invest during the accumulation phase, the more you will receive at retirement.  Contributions are made to selected investments within the allowable funds offered by the annuity. 

Once you finish making contributions, you enter into the payout phase which is when you start receiving your cash.  There are two options; an immediate lump sum distribution or equal periodic payments.  It is possible to request periodic payments for a fixed period of time or to request payments in perpetuity. 

If you plan on withdrawing your money before the age of 59.5, you will be responsible for "surrender charges" as specified by the terms and conditions of your annuity.  Make sure to check into this.  Additionally, you will be subject to a 10% federal penalty for the early withdrawal.

Variable Annuity Fees


Here is the tricky part.  There are fees associated with the variable annuity.  It is extremely important to keep a close eye and understand the fees associated with your plan.  Let's review a few that you should be aware of. 
  1. We discussed surrender charges.  Remember, if you withdraw your money early, you will most likely incur penalties from your annuity and federally.  There is a "surrender period" typically between 6 to 8 years.  The stipulation is that if you withdraw your funds within the surrender period, you will owe a surrender fee to cover the expenses of the sales agent.  Most of the time, it is graduated as the years pass. 
     
  2. Death Benefits - The insurance company is basically adding a life insurance policy to your annuity and charging you for it.  There is typically a 1 to 1.25% fee on your account per year that compensates the insurance company for providing you with death benefits.  Profits derived from this expense are typically used to pay the sales agent as well.
     
  3. Mutual Fund Expenses - Be careful to research the mutual funds that are offered to you by the annuity company.  Many times, they only include load funds which chart you up front to buy into the mutual fund.  This is yet another fee that can hurt your performance over the long run.  I will never invest in a mutual fund with a load.
     
  4. Admin Fees - Most annuities will render an admin fee to cover the costs of record keeping and other common administrative functions.  Typically, they can be between .10% and .20%.
     
  5. Investment Transfer Fees - Be wary of annuities that charge you a fee to transfer between different investment options.
In conclusion, always ask a ton of questions to your sales agent and make sure you understand exactly what you are getting into.  There are alot of crooked people in the world of annuities.
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