What is a variable annuity, and how does it work? 

What is variable annuity

A variable annuity is a type of deferred annuity that allows you to invest in market-based investment options within an insurance product. The value of the annuity can increase or decrease depending on the performance of the underlying investments. It’s commonly used as part of a long-term retirement strategy because it offers tax-deferred growth and the option to convert savings into income later in life.

Unlike fixed annuities, which provide a guaranteed rate of growth, variable annuities offer growth potential tied to the securities markets. This means returns aren’t guaranteed, and the account value may fluctuate over time.

Annuity basics

To better understand a variable annuity, it helps to first understand what an annuity is.

An annuity is a long-term insurance product designed to help you accumulate savings or convert assets into a stream of income. Some annuities focus primarily on guaranteed growth, while others emphasize market participation. A variable annuity falls into the latter category, offering investment flexibility during your working years and the option to create predictable income in retirement.

Benefits of variable annuities

Variable annuities offer several features that may support long-term retirement planning:

• Tax-deferred growth, which allows earnings to compound without current income taxes
• Access to market-based investment options for potential long-term growth
• The ability to convert savings into lifetime income through annuitization or optional income riders¹
• Optional benefits, such as death benefits or principal protection features, depending on the contract

Variable annuity example

For example, imagine a 45-year-old professional who has already maxed out her 401(k) contributions and wants to continue saving for retirement. She purchases a variable annuity and allocates her contributions among several market-based investment options. Over time, her account value fluctuates with the market but grows on a tax-deferred basis. At retirement, she chooses to convert a portion of the account into lifetime income, creating a predictable stream of payments to supplement Social Security and other savings.

How do variable annuities work?

There are two main ways to grow your retirement savings with a deferred annuity. A fixed annuity grows at a steady rate that is set when you purchase it. A variable annuity can potentially grow in relation to the growth of the securities markets.

A variable annuity has two phases: the accumulation phase and the distribution phase. During the accumulation phase, the insurance company will offer a variety of investment options that you can use to develop a diversified portfolio. These investment options are invested in stocks, bonds, or other types of investments. During the accumulation phase, you can make additional contributions if you wish. Because these investments are tied to market performance, the account value may increase or decrease over time, and growth is not guaranteed.

During the distribution phase, you can begin taking withdrawals or choose to annuitize the contract, which converts some or all of the account value into a stream of payments. The amount and duration of payments depend on the options selected and the terms of the annuity.

Where can I invest my variable annuity contributions?

The insurance company will provide you with a broad selection of market-based investment options that span a range of different asset classes. If you are a hands-on investor, you can choose the funds or investment options for your portfolio yourself. But if you prefer, many insurance companies, including New York Life, offer customized portfolios for various investment styles. With each investment option, it’s important to consider the objectives, risk factors, and potential fees. Your personal risk profile should guide you as you decide how you will diversify your portfolio of investment options within the variable annuity.

How are variable annuities regulated?

Variable annuities are subject to the rules of a number of different regulatory bodies. Because they are insurance products, they are subject to state insurance law. And because they have investment elements, they are subject to the Internal Revenue Code, as well as federal laws that apply to securities products. Variable annuities are regulated by the Securities and Exchange Commission (SEC), and the registered representatives who help you create your variable annuity are overseen by the Financial Industry Regulatory Authority (FINRA). Although variable annuities are regulated by these agencies, the products themselves are not approved by the regulators.

Whenever you invest money in a market, you are taking a risk. For many people, the opportunity for growth outweighs those risks, but depending on your retirement goals and where you are right now, you’ll need to weigh the risk factors carefully. In general, the closer you are to retirement, the less risk you may want in your portfolio.

There are often optional riders you can purchase for your annuity that may help reduce downside risk. These riders can ensure that your principal contributions won’t diminish, even if the market declines, subject to contract terms and fees. This additional protection typically comes at an added cost.

Are there variable annuity fees?

Variable annuities are unique investment products because they offer guarantees, which could include a death benefit and access to principal-protection riders. But these guarantees come with fees. Variable annuity fees may include mortality and expense charges, sales and withdrawal charges, administrative fees, investment management fees, and rider charges. With any investment product, it’s important to fully understand all the fees you’ll be paying, as they can materially affect the growth rate of your savings. Always ask for a prospectus that clearly defines the benefits and fees of any investment so you can compare them. If you have questions, consult your financial professional for a detailed explanation.

Are variable annuities tax-deferred?

All earnings in variable annuities are tax-deferred. This means you generally do not pay taxes on investment gains each year while the money remains inside the annuity. Instead, taxes are typically due when you begin withdrawals or start annuity payments².

An annuity purchased with after-tax funds, or a nonqualified annuity, does not have IRS contribution limits in the same way that a 401(k) or IRA does. Earnings grow tax-deferred, and you pay taxes on earnings (not the principal) when you begin to withdraw funds or begin annuity payments.

This tax-deferred treatment can allow earnings to compound over time without annual taxation. However, when you withdraw money, earnings are generally taxed as ordinary income. In most cases, withdrawals taken prior to age 59½ may be subject to a 10% federal tax penalty in addition to ordinary income taxes.

With a tax-qualified annuity, you invest pretax money and pay no taxes until you withdraw your money or begin annuity payments. At that point, you will owe ordinary income taxes on the withdrawals or annuity payments.

Note that tax-qualified plans already provide tax deferral under the Internal Revenue Code, so the annuity does not provide additional tax deferral beyond the plan itself. Since variable annuities offer both insurance and investment features, they may be subject to more fees than other tax-qualified funding vehicles.

Is a variable annuity a good idea?

A variable annuity isn’t right for everyone. Depending on your situation, other investment options or a fixed annuity may be a better fit. Variable annuities can be an effective way to supplement retirement income. A variable annuity investment portfolio can be built to address a variety of return and risk objectives. Consult your financial professional to review all available options.

Scenario #1: Starting early

You are in your 40s and just got a promotion at work. You’re already contributing the maximum to your company-provided 401(k) and would like to find a way to save further for a comfortable retirement. A variable deferred annuity can provide an additional way to grow tax-deferred savings in the market. When you annuitize those savings, you may be able to receive annuity payments for your lifetime, subject to the terms of the contract.

Scenario #2: Converting at retirement

You are retiring next year and want to convert some of your investments into an annuity to help protect against running out of savings. You first look at an immediate annuity, which will begin payouts right away, but the monthly payout may be modest. You’d like some market-based growth, and since you plan to live off other investments for at least a few years, a variable deferred annuity may be worth more when you decide to annuitize these savings.

How do variable annuities compare with 401(k)s and IRAs?

These tax-deferred retirement savings vehicles are similar to the accumulation phase of variable annuities. Most financial professionals advise that you take full advantage of them, but both have caps on how much you can contribute each year. After you have maxed out your 401(k) or IRA contributions, you may wish to contribute to a variable annuity. Bear in mind that 401(k) and IRA savings are not guaranteed to last for your entire life, as lifetime annuities are. You could, however, roll over a portion of your 401(k) or IRA savings into an immediate lifetime annuity when you are ready for retirement.

Conclusion

Variable annuities are one of many important retirement savings tools. To find the right mix and ensure that you and your family are taken care of now and in the future, you should have a knowledgeable financial professional on your side. We can help you go over your retirement checklist and create a customized plan to support your long-term retirement goals.

Variable Annuity FAQs

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¹Any guarantees of the variable annuity are based on the claims-paying ability of the issuer
²Withdrawals may be subject to regular income tax and, if made prior to age 59 ½ , may be subject to a 10% IRS penalty. Surrender charges may also apply.

Please consider the charges, risks, expenses, and investment objectives carefully before purchasing a variable annuity. The product and fund prospectuses contain this and other information and can be obtained from a financial professional. Read the prospectuses carefully before you invest or send money.

New York Life Annuities are issued by New York Life Insurance and Annuity Corporation (NYLIAC), A Delaware Corporation, or by New York Life Insurance Company. Variable annuities are offered by NYLIFE Securities LLC, member FINRA/SIPC. Both NYLIAC and NYLIFE Securities LLC are wholly owned subsidiaries of New York Life Insurance Company, 51 Madison Avenue, New York, NY 10010.

Guarantees are based on the claims-paying ability of the issuer.

Sources:

U.S. Securities and Exchange Commission (SEC)
Variable Annuities – Investor Bulletin
https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_variableannuities⁠

Investor.gov – Variable Annuity Glossary
https://www.investor.gov/introduction-investing/investing-basics/glossary/variable-annuity⁠

FINRA (Financial Industry Regulatory Authority)
Variable Annuities Overview
https://www.finra.org/investors/learn-to-invest/types-investments/annuities/variable-annuities⁠

Internal Revenue Service (IRS)
Publication 575 – Pension and Annuity Income
https://www.irs.gov/publications/p575⁠

Publication 590-B – Distributions from Individual Retirement Arrangements (IRAs)
https://www.irs.gov/publications/p590b⁠

Retirement Plans Information
https://www.irs.gov/retirement-plans⁠

U.S. Code – Internal Revenue Code Section 72 (Annuities)
26 U.S. Code § 72 – Annuities; certain proceeds of endowment and life insurance contracts
https://www.law.cornell.edu/uscode/text/26/72⁠

National Association of Insurance Commissioners (NAIC)
Annuities Consumer Guide
https://content.naic.org/consumer/annuities.htm⁠