How Does a Variable Annuity Work?

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Variable annuities are a contract between and investor and an insurance company in which the insurer agrees to make periodic payments to the investor starting at a specific time in the future. The investor agrees to fund the investment either with a lump sum initial investment or periodic payments over time.

Accumulation Phase

During the accumulation phase, monies is collected from the investor and invested. The investor allocates the investment. Typically it is invested into mutual funds so that money is available to distribute in the future.

Payout Phase

When the money is to begin distributing back to the investor, this is called the payout phase. The investor can take distribution in a lump sum payment or a fixed amount over a certain time period. Depending on the contract terms, the amount and duration of the payments to the investor may vary.

Death Benefit

Variable annuities have a death benefit. If the investor dies before monies are to begin distribution, a guaranteed amount can be distributed to the investor's designated beneficiary. The amount varies by contracts.

Variable Annuity Fees

A drawback to variable annuities is the high fees often charged. Such fees include account maintenance fees, fund expenses and surrender charges. Surrender charges or the fee you must pay to cancel the variable annuity contract is particularly high in the first few years of the contract. Variable annuities are long-term investments so an investor should keep this in mind before entering into a variable annuity contract.

Tax Benefits of Variable Annuities

A major benefit of variable annuities is the tax benefits. You do not have to pay taxes on the investment gains or income from the investments until you start to take a distribution. When you do take a distribution during your retirement, often it will be at a much lower tax rate.