A variable annuity is a contract with an insurance company that lets you invest in market-based sub-accounts — similar to mutual funds — with the potential for growth, guaranteed income, and tax-deferred accumulation. Unlike a fixed annuity, your account value can go up or down depending on how those investments perform.
For the right person, a variable annuity offers something no other product does: market upside, tax deferral, and the option to turn your savings into guaranteed lifetime income. For the wrong person, it’s an expensive, complicated product that can erode your nest egg.
This guide breaks down exactly how variable annuities work, what they cost, and whether one belongs in your retirement plan.
What Is a Variable Annuity?
A variable annuity is an insurance contract that grows based on how you invest your premium. You choose from a menu of sub-accounts — typically stock funds, bond funds, and balanced funds — and your account value rises and falls with the market.
Unlike a fixed annuity, which locks in a guaranteed interest rate, a variable annuity offers no floor on your returns. In a strong bull market, you could double your money. In a bear market, you could lose a significant portion of it.
That’s the tradeoff: variable annuities offer higher potential returns in exchange for market risk.
Who issues variable annuities?
Variable annuities are issued by life insurance companies and sold through brokers, financial advisors, and insurance agents. Because they contain securities (the sub-accounts), they are regulated by both the SEC and FINRA, and the person selling them must hold a securities license in addition to an insurance license.
How Does a Variable Annuity Work?
Variable annuities have two phases: the accumulation phase and the distribution phase.
Accumulation Phase
You put money into the annuity — either as a lump sum or through a series of payments. That money is allocated among sub-accounts of your choosing. The value of your contract grows (or shrinks) based on those investment results, minus ongoing fees.
Growth inside a variable annuity is tax-deferred, meaning you won’t owe taxes on gains until you start taking withdrawals. This mirrors how a traditional IRA works, except there are no contribution limits on non-qualified variable annuities.
Distribution Phase
When you’re ready to receive income, you have options:
- Annuitize: Convert your account into a stream of income payments — monthly, quarterly, or annually — for life or a set period.
- Systematic withdrawals: Take periodic withdrawals without annuitizing, maintaining flexibility.
- Use a living benefit rider: Activate a guaranteed withdrawal benefit (GLWB) that provides income for life regardless of account performance.
- Lump sum: Withdraw your full account value (subject to surrender charges and taxes).
Types of Variable Annuities
Deferred Variable Annuity
The most common type. You invest now and defer income until retirement — typically 10 to 20 years away. This gives your sub-accounts time to grow and lets you benefit from years of tax-deferred compounding.
Immediate Variable Annuity
You make a lump-sum payment and begin receiving income almost immediately — usually within 30 days. Payments vary each period based on the performance of your chosen sub-accounts. Less common and less predictable than a fixed immediate annuity.
Registered Index-Linked Annuity (RILA)
A newer hybrid that falls between a fixed index annuity and a variable annuity. RILAs offer market-linked growth with a partial buffer against losses — you accept some downside risk in exchange for higher upside potential. See our full RILA guide for how these compare.
Variable Annuity Fees — What You’ll Actually Pay
Fees are the single biggest drawback of variable annuities. Here’s what you’re typically paying:
| Fee Type | Typical Range | What It Covers |
|---|---|---|
| Mortality & Expense (M&E) charge | 0.50% – 1.50%/yr | Insurance risk, death benefit guarantee |
| Administrative fee | 0.10% – 0.30%/yr | Recordkeeping, contract maintenance |
| Sub-account expenses | 0.40% – 1.50%/yr | Underlying fund management (like mutual fund expense ratios) |
| Living benefit rider | 0.50% – 1.50%/yr | Guaranteed income, GLWB, GMIB |
| Death benefit rider | 0.25% – 0.75%/yr | Enhanced death benefit above account value |
Add it all up, and you’re often paying 2% to 4% per year in combined fees. On a $200,000 contract, that’s $4,000 to $8,000 annually — money that doesn’t compound over time.
That’s why variable annuities require a genuine long-term horizon. You need enough years of market growth to outpace the fee drag before you start withdrawals.
Variable Annuity vs. Fixed Annuity: Key Differences
The core difference comes down to who bears the investment risk: you or the insurance company.
| Feature | Variable Annuity | Fixed Annuity |
|---|---|---|
| Return | Market-based (up or down) | Guaranteed rate |
| Investment risk | You bear it | The insurance company bears it |
| Principal protection | No (without rider) | Yes |
| Tax deferral | Yes | Yes |
| Typical fees | 2% – 4%/yr | 0% (built into rate) |
| Upside potential | Unlimited | Capped at stated rate |
| Best for | Long time horizon, risk tolerance | Capital preservation, guaranteed growth |
If you’re within 5 to 10 years of retirement and can’t afford significant losses, a fixed annuity — particularly a multi-year guaranteed annuity (MYGA) — is almost always a safer fit.
Variable Annuity vs. Fixed Index Annuity
Many retirees explore both options when weighing market participation against downside protection. The short version: a fixed index annuity (FIA) gives you market-linked growth with a floor of zero — you can’t lose principal due to market performance.
A variable annuity offers potentially higher returns but also real downside exposure. See our in-depth fixed index annuity vs. variable annuity comparison for a detailed side-by-side breakdown.
Variable Annuity Riders: Adding Guarantees
Riders are optional add-ons that enhance your contract — usually for an additional annual fee. The most valuable for retirement planning:
Guaranteed Lifetime Withdrawal Benefit (GLWB)
Guarantees you can withdraw a set percentage of a “benefit base” each year for life, even if your actual account value drops to zero. The benefit base typically grows at 5% to 7% annually during the deferral period, regardless of market performance.
Example: Robert, age 60, puts $250,000 into a variable annuity with a GLWB rider. His benefit base grows at 6% annually. At age 70, his benefit base is roughly $447,700 — even if markets were flat. He can withdraw 5% of that per year ($22,385) for life.
Guaranteed Minimum Income Benefit (GMIB)
Guarantees you can annuitize at a minimum income amount, regardless of account value. Less flexible than GLWB, but provides a retirement income floor.
Enhanced Death Benefit
Ensures your beneficiaries receive at least your original premium — or the highest account anniversary value — rather than just the current market value. Particularly valuable if markets decline late in the accumulation phase.
How Are Variable Annuities Taxed?
Variable annuities grow tax-deferred — you pay no taxes on gains until you make withdrawals. That’s the main tax benefit. But when you do withdraw, the tax treatment is less favorable than you might expect.
- Withdrawals taxed as ordinary income: Gains come out first (LIFO accounting) and are taxed at your regular income tax rate — not the lower capital gains rate.
- 10% early withdrawal penalty: If you take money out before age 59½, you owe a 10% federal penalty on the taxable portion, on top of regular income taxes.
- No step-up in basis: Unlike stocks or mutual funds held in a taxable account, variable annuities don’t get a step-up in basis at death. Beneficiaries owe ordinary income taxes on all gains.
- Non-qualified vs. qualified: If your annuity is inside an IRA or 401(k), the entire distribution is taxable as ordinary income (since pre-tax money funded it).
Tax deferral is most valuable when you’re in a high tax bracket now and expect to be in a lower bracket in retirement. For many retirees today, this calculation doesn’t favor variable annuities over a simple taxable brokerage account.
Surrender Charges in Variable Annuities
Most variable annuities have a surrender period of 5 to 9 years. If you withdraw more than your free withdrawal allowance (typically 10% per year) during that window, you’ll pay a surrender charge — usually starting at 7% to 9% and declining by 1% per year.
Example: A variable annuity with a 7-year surrender schedule starting at 7%. If you surrender the contract in year two, you’d pay a 6% charge on the surrendered amount.
Read our full guide on annuity surrender charges to understand how they’re calculated and how to avoid them.
Pros and Cons of Variable Annuities
Pros
- Unlimited upside: No cap on how much your sub-accounts can grow during a bull market
- Tax-deferred growth: Gains compound without annual tax drag
- Guaranteed income option: GLWB and GMIB riders provide retirement income security
- No contribution limits: Unlike IRAs, you can contribute as much as you want to a non-qualified contract
- Death benefit protection: Beneficiaries receive at least the original premium with the basic death benefit
- Creditor protection: In many states, annuity values are protected from creditors
Cons
- High fees: 2% to 4% annually significantly reduce net returns
- Market risk: Account value can decline substantially — you can lose money
- Complexity: Riders, sub-accounts, benefit bases, and surrender schedules are hard to compare across products
- Tax inefficiency on gains: Ordinary income tax on withdrawals vs. capital gains rates for stocks held outside an annuity
- Surrender charges: Locking up capital for 5 to 9 years limits flexibility
- Salesperson incentives: High commissions (3% to 8%) create potential conflicts of interest
Who Should Consider a Variable Annuity?
A variable annuity may make sense if all of the following are true:
- You’re at least 15 to 20 years from needing the money — long enough for market growth to overcome fees
- You’ve already maxed out your IRA and 401(k) and want additional tax-deferred growth
- You’re comfortable with market volatility and can afford to lose a portion of your investment
- You want a guaranteed lifetime income floor, and the GLWB rider makes the total cost worthwhile
- You’re in a high-income tax bracket now and expect to be in a lower bracket in retirement
Who Should Avoid Variable Annuities?
Variable annuities are frequently oversold. Skip them if:
- You’re within 10 years of retirement — there isn’t enough runway to recover from a market drop after fees
- You prioritize capital preservation — a fixed annuity or MYGA locks in your principal
- You haven’t yet maxed out tax-advantaged accounts (IRA, 401k, HSA) — those are better first stops for tax deferral
- You may need the money within the surrender period
- You’re being pitched by someone who seems to benefit heavily from the sale — get a second opinion from a fee-only fiduciary advisor.
How to Buy a Variable Annuity
Variable annuities are sold through licensed securities and insurance agents, wirehouses, independent broker-dealers, and banks. Because the product contains securities, the selling agent must hold a FINRA Series 6 or Series 7 license.
Before you sign:
- Read the prospectus. Every variable annuity has one. It discloses all fees, sub-account options, rider terms, and surrender schedules.
- Compare total fees. Ask for a breakdown of M&E, admin, sub-account expenses, and any rider fees.
- Understand the surrender schedule. Know exactly what it costs to get out early.
- Check the insurer’s financial strength. Look up AM Best ratings — stick with A-rated or better carriers.
- Consider a fee-only advisor. A fiduciary who doesn’t earn commissions can give you objective guidance.
If you’re comparing variable annuities to safer alternatives like fixed annuities or MYGAs, request a free quote from My Annuity Store — we’ll show you current rates from top-rated carriers so you can compare your options side by side.
Frequently Asked Questions About Variable Annuities
Can you lose money in a variable annuity?
Yes. Because your account value is tied to market-based sub-accounts, a significant market downturn can reduce your contract value below what you invested. Some riders (like a GLWB or return-of-premium death benefit) provide partial protection, but these come at an additional annual cost.
What is the average fee for a variable annuity?
Total fees typically range from 2% to 4% per year when you add up the mortality & expense charge, administrative fee, sub-account expenses, and any rider fees. By comparison, a low-cost index fund costs under 0.10% per year — making fees the central question when evaluating any variable annuity.
What is the difference between a variable annuity and a mutual fund?
Both invest in market-based portfolios, but a variable annuity wraps those investments inside an insurance contract. That adds tax deferral, a death benefit, and optional income guarantees — but also adds fees of 2% to 4% per year. Gains inside a variable annuity are taxed as ordinary income on withdrawal, not at the lower capital gains rate that applies to mutual funds held in a taxable account.
How is a variable annuity taxed?
Growth inside a variable annuity is tax-deferred — you pay no taxes until you withdraw. When you do withdraw, gains are taxed as ordinary income. Withdrawals before age 59½ are also subject to a 10% IRS penalty on the taxable portion. Variable annuities do not receive a step-up in cost basis at death, so beneficiaries owe income taxes on all accumulated gains.
Is a variable annuity the same as an RILA?
No. A Registered Index-Linked Annuity (RILA) is a distinct product that links growth to a market index with a partial buffer against losses. A variable annuity invests directly in sub-accounts with full market exposure. RILAs offer more downside protection than variable annuities but less than fixed index annuities.