A variable annuity is an insurance contract that also has an investment component. The insurance company provides the contract owner with future income payments based on the initial contract value and subsequent investment performance. Any investment gains are tax-deferred until withdrawn. These types of annuities are referred to as “variable” because the account value will fluctuate based on the performance of the underlying investments.

Variable annuities are primarily used for the following reasons:

  • Tax-deferral
  • Guaranteed income
  • Insurance death benefits

What are the insurance benefits?

The benefits include a death benefit, the ability to annuitize the policy to receive a guaranteed stream of income, and other features, known as “riders.” These benefits, and their associated costs, can vary from one policy to another.

What is annuitization?

Annuitization is the process of converting an annuity’s value into a stream of guaranteed income for a specific length of time. Annuitizing a policy is a permanent decision and triggers the stream of income payments. It also results in the loss of control over the contract’s asset value.
The amount of guaranteed income received depends upon the contract’s value, contract owner’s age, life expectancy, and the chosen income option. Several income options exist, including:

  • Life-only, where payments end when the annuitant dies;
  • Joint and survivor, where payments continue until the death of the survivor;
  • Life with period certain, which pays for the longer of the annuitants’ lifespan or a fixed period, usually 10 to 20 years.

Only a portion of the income received is taxable; part of each payment is considered a return of basis, or the amount paid into the annuity, while the remaining portion of each payment is taxed as ordinary income.

Should you annuitize?

Those concerned with outliving their money, and who prefer the stability of a fixed monthly income stream, or do not intend to leave an inheritance to their beneficiaries may choose to annuitize.

Is there an alternative to annuitizing?

Annuitizing is not required to access the annuity’s cash value – the money can be withdrawn at any time. Withdrawals are considered to first come from earnings, until the earnings are depleted, and then from the original contract value, or cost basis. Any earnings distributed prior to age 59½ are subject to a 10 percent penalty and potentially surrender charges. Some annuities will allow 5 – 15 percent distributions each year free from surrender charges.

Such withdrawals can make sense for people who want to preserve the ability to annuitize later and who may have intermittent income needs. Additionally, people who are outside of the age and surrender period window, and in a lower tax bracket now than anticipated for the future, may make systematic earnings withdrawals to reach their original contract value, at which point additional withdrawals are tax free. Careful planning is needed, as a withdrawal could make more of Social Security income subject to tax, could trigger increased Medicare premiums, and could accelerate tax brackets.

What are the death benefits?

Death benefits depend upon whether the contract was annuitized prior to death or not.

If the contract was annuitized, those income payments may or may not continue for the beneficiary’s benefit—it depends on the income option selected at annuitization.

A surviving spouse who inherits an annuity prior to annuitization has several options, including: changing the contract into their own name, taking an immediate lump-sum payment, taking withdrawals over a five-year period, or receiving payments over their own life expectancy. Non-spouse beneficiaries have the same options as a surviving spouse, except for the option to change the contract into their own name.

Some insurance providers offer a standard death benefit – the greater of the account value or the premiums paid into the policy, minus any withdrawals. Other providers offer a death benefit equal to the account value. Enhanced death benefit riders can be purchased for an additional fee.

Upon death, there is no step-up in basis for the annuitants’ beneficiaries, and the annuity is included in the deceased estate for estate tax purposes.

Can I get out of the annuity?

Prior to annuitization, there are a few ways to get out of an annuity. If systematic withdrawals aren’t appealing, a variable annuity can be “surrendered,” or cancelled. Surrendering a policy can make sense if the annuity’s combined investment and insurance costs are higher than what could be obtained independently. This option might appeal to people who are:

  • In a low tax bracket;
  • Over age 59½ and not subject to the 10 percent penalty;
  • Willing to pay the one-time surrender charge, if applicable;
  • No longer need the annuity’s insurance benefit;
  • Concerned about the financial strength of the insurance company.

If an annuity contract is within the surrender period, a surrender fee must be paid to cancel the policy. This one-time fee can range from 0 – 8 percent. It’s a fee that may be justified, given many annuities’ high annual costs and expenses, and limited and/or poor investment choices.
Another way to get out of an annuity is to do what’s referred to as a “1035 exchange.” Section 1035 of the tax code allows a policyholder to transfer funds from one annuity contract to another, without paying taxes on the transaction. Reasons to consider a 1035 exchange over surrendering the annuity include:

  • The existing annuity has a large gain;
  • The individual is tax sensitive and doesn’t want to pay any additional taxes;
  • The existing annuity has high expenses and poor investment choices, and surrendering the existing policy would trigger a penalty, increase Medicare premiums, affect Social Security taxes or accelerate tax brackets.

Prior to doing a 1035 exchange, it’s important to review the potential benefits lost by switching providers. For example, an existing policy may have a death benefit that far surpasses the annuity’s current market value. This should only be a factor if someone needs the insurance. Additionally, if the annuity contract is within the surrender period, a surrender fee will be incurred with a 1035 exchange.

What is Vista’s take?

We strongly believe in keeping investments and insurance separate. Someone who is reliant on death benefits for income needs should first consider purchasing term insurance. Term insurance is significantly less expensive outside of an annuity contract and can be cancelled without penalty when it’s no longer needed.

People who can self-insure, or have enough assets or income to cover their needs without an insurance policy, do not need a variable annuity.

While every client situation is unique, it has often made the most sense for our clients to cancel their annuity contracts entirely. In certain cases, however, surrendering the original annuity and transferring it into a lower-cost annuity via a 1035 exchange has been the best solution.