A variable annuity is a tax-deferred retirement vehicle that allows you to choose from a selection of investments, and then pays you a level of income in retirement that is determined by the performance of the investments you choose in the sub-accounts (essentially mutual funds) offered within the annuity.
Unlike their fixed counterparts, variable annuities are designed to pump up your savings by giving you a chance for long-term capital growth. As with fixed annuities, gains escape taxation until withdrawal. Because of the growth potential, a variable annuity may be more likely than a fixed annuity to outpace inflation.
Variables have drawbacks that can erode their advantages, however. An obvious one is investment risk: if the investments you choose for your annuity decline, the value of your annuity will also decline – and that means a lower payout to you.
Second is an annoying tax twist: Any long-term capital gains you build up in stock and bond subaccounts are taxed at ordinary income rates when you withdraw them. This means that high-income investors are effectively converting long-term capital gains into ordinary income that can face far higher rates.
And then there are variables’ fees; steep sales commissions (often 4%) and ongoing management fees and insurance charges, which combined can run as high as 2% to 3% a year. Compare that with regular no load index funds, which usually have annual expenses of less than 0.50% (for index funds).