A tax-deferred variable annuity combines features of both mutual funds and insurance policies. Typically, when you invest in a variable annuity, your money is placed in a series of subaccounts that -- similar to a mutual fund -- track various stock or bond investments. The insurance component of the annuity provides you with a death benefit. Beyond that, variable annuities carry a series of negative features that you should understand before you make your investment.
Variable annuities carry a series of expenses that make them more costly than many other types of investments. In addition to the management fees collected to run the investments, annuities charge mortality and risk fees to pay for the insurance. If you add special features to your annuity, such as principal protection or long-term health insurance, your expenses will go up commensurately. Variable annuities also charge administrative fees for record-keeping and miscellaneous expenses. As with mutual funds and other investments, fees for variable annuities can vary considerably from company to company.
Variable annuities are intended to be long-term investments. If you need to take money out of your annuity prematurely, expect to be hit with a significant surrender charge. While you usually don't have to pay an upfront sales charge to buy an annuity, you'll most likely face a fee of up to 7 percent of your assets if you choose to sell in the first year after purchase. Typically, this fee will decline every year until it reaches zero, which may take seven to 10 years, or even longer.
Taxation of Earnings
You can usually withdraw your contributions to a variable annuity without penalty, since you've already been taxed on that money. However, all of the earnings you take out of your annuity will be taxed at ordinary income rates just like salary or hourly wages. If most of your earnings come from capital gains, such as stock market profits, the structure of an annuity can prove extremely disadvantageous from a tax perspective. Normally, capital gains are taxed at much lower rates than ordinary income. When you invest in a variable annuity, any capital gains you earn are taxed at the less-preferential ordinary income rates, which could result in a significant amount of additional tax.
Early Distribution Penalty
If you take money out of your variable annuity before you reach age 59 1/2, you'll face more than taxes. The Internal Revenue Service assesses a 10 percent penalty on variable annuity distributions taken before age 59 1/2. This is the same rule that applies to early withdrawals from other retirement accounts, such as IRAs.
After receiving a Bachelor of Arts in English from UCLA, John Csiszar earned a Certified Financial Planner designation and served 18 years as an investment adviser. Csiszar has served as a technical writer for various financial firms and has extensive experience writing for online publications.