- A variable annuity invests in market subaccounts (similar to mutual funds), meaning your account value can go up or down with the market.
- Total annual fees typically range from 2% to 3.5%, making variable annuities the most expensive annuity type — fee awareness is critical.
- Optional riders can add guaranteed income for life (GLWB) and enhanced death benefits, but each rider adds 0.5–1.5% in annual cost.
- Earnings grow tax-deferred but are taxed as ordinary income on withdrawal — not at the lower capital gains rate.
- Variable annuities are best suited for investors who have maxed out other tax-advantaged accounts and want market exposure with a guaranteed death benefit over a long time horizon.
- What Is a Variable Annuity?
- How a Variable Annuity Works
- Variable Annuity Fees: The Complete Picture
- Variable Annuity Guarantees
- How Variable Annuities Are Taxed
- Variable Annuities vs. Alternatives
- Who Should (and Shouldn't) Buy
- Variable Annuity Misconceptions
- Already Own a Variable Annuity?
- Frequently Asked Questions
What Is a Variable Annuity?
A variable annuity is a contract between you and an insurance company in which your premium is invested in a menu of market-based investment options called subaccounts. Unlike fixed or indexed annuities — where the insurer bears the investment risk — a variable annuity places the investment risk on you. Your account value rises and falls directly with the performance of the subaccounts you select.
This direct market exposure is the defining characteristic of a variable annuity and the source of both its greatest advantage and its greatest risk. In strong markets, a variable annuity can significantly outperform fixed-rate products. In downturns, your account value can decline — sometimes sharply. There is no floor protecting your principal from market losses within the subaccounts themselves.
What separates a variable annuity from simply investing in mutual funds through a brokerage account? Two things: tax-deferred growth and insurance guarantees. All investment gains inside a variable annuity compound without annual taxation. And nearly every variable annuity includes a standard death benefit that guarantees your beneficiaries will receive at least your original premium (minus withdrawals) if you die before annuitizing — regardless of how the market performed.
Variable annuities also offer optional riders that can guarantee lifetime income or lock in market gains for an additional fee. These guarantees are backed solely by the financial strength and claims-paying ability of the issuing insurance company. Variable annuities are not FDIC-insured and are classified as securities, which means they must be registered with the SEC and sold with a prospectus.
How a Variable Annuity Works
A variable annuity moves through two main phases: the accumulation phase, during which your money is invested and growing, and the distribution phase, during which you begin taking income. Understanding each phase is essential to evaluating whether a variable annuity fits your financial plan.
The Accumulation Phase
When you purchase a variable annuity, you allocate your premium across the contract’s available subaccounts. Most contracts offer between 30 and 100 subaccount options spanning domestic stocks, international equities, bonds, balanced funds, and money market instruments. Each subaccount has its own investment objective, risk profile, and management team — much like a mutual fund family.
You choose your allocation based on your risk tolerance, time horizon, and financial goals. For example, a 55-year-old with 15 years until retirement might allocate 60% to equity subaccounts and 40% to bond subaccounts. A 65-year-old nearing income needs might shift toward a more conservative allocation.
During the accumulation phase, you can typically rebalance among subaccounts without triggering a taxable event — a significant advantage over a taxable brokerage account, where switching funds generates capital gains. Most contracts allow unlimited transfers between subaccounts at no charge, though some impose short-term trading restrictions (e.g., one transfer per subaccount per month) to discourage market timing.
Your account value during this phase equals the total market value of your subaccount holdings minus any applicable fees and charges. It fluctuates daily based on market performance.
The Distribution Phase
When you are ready to take income, you typically have three options:
Systematic withdrawals: You withdraw a specific dollar amount or percentage on a regular schedule (monthly, quarterly, annually) from your account. Your remaining balance continues to be invested. This approach offers maximum flexibility but provides no guarantee that your money will last for life.
Annuitization: You convert your account value into a guaranteed stream of payments for a set period or for life. Once you annuitize, you typically cannot access the remaining principal as a lump sum. The insurance company assumes the longevity risk, guaranteeing payments regardless of how long you live.
Guaranteed withdrawal benefit (if elected): If you purchased a GLWB rider during the accumulation phase, you can withdraw a guaranteed percentage of your benefit base each year for life — even if your actual account value drops to zero. This approach combines the income guarantee of annuitization with more flexibility, since your remaining account value (if any) is still accessible.
Variable Annuity Fees: The Complete Picture
Variable annuities carry the highest fees of any annuity type. Understanding the full fee stack is critical because fees compound against your returns every year. A 1% difference in annual fees can reduce your ending balance by 20% or more over a 20-year period.
Mortality and Expense (M&E) Risk Charges
This is the largest fee in most variable annuities, typically ranging from 1.00% to 1.50% of your account value per year. The M&E charge compensates the insurance company for the mortality risk it assumes through the death benefit guarantee and for the expense risk of administering the contract over your lifetime. This charge is deducted daily from your subaccount values.
Investment Management Fees
Each subaccount charges its own management fee, similar to a mutual fund expense ratio. These typically range from 0.50% to 1.00% annually, depending on the subaccount’s investment style. Actively managed equity subaccounts tend to charge more than index-based or bond subaccounts. These fees are deducted from the subaccount’s net asset value before your returns are calculated.
Administrative Fees
Most contracts charge a flat administrative fee or a percentage-based charge, typically 0.10% to 0.15% annually. Some contracts charge a flat dollar amount (e.g., $30–$50 per year) that is waived if your account value exceeds a certain threshold. This covers record-keeping, statement generation, and contract administration.
Optional Rider Fees
Riders that add living benefits (guaranteed income) or enhanced death benefits typically cost an additional 0.50% to 1.50% per year. These are charged against either your account value or your benefit base, depending on the rider. A guaranteed lifetime withdrawal benefit (GLWB) alone commonly costs 0.75–1.25% annually.
Surrender Charges
If you withdraw more than your free-withdrawal allowance (typically 10% of your account value per year) during the surrender period, you will pay a surrender charge. These charges typically start at 6–8% in year one and decline by 1% each year until they reach zero, usually after 6–8 years. Some contracts have shorter or longer surrender periods.
Fee Scenarios: What You Actually Pay
| Fee Component | Base Contract Only | With Income Rider | Fully Loaded |
|---|---|---|---|
| M&E Risk Charge | 1.25% | 1.25% | 1.25% |
| Investment Management | 0.65% | 0.65% | 0.65% |
| Administrative | 0.10% | 0.10% | 0.10% |
| GLWB Income Rider | — | 0.95% | 0.95% |
| Enhanced Death Benefit Rider | — | — | 0.50% |
| Total Annual Cost | 2.00% | 2.95% | 3.45% |
These fees are deducted from your account value every year, regardless of investment performance. In a year when your subaccounts return 8%, a fully loaded contract would net you approximately 4.55% after fees. In a flat year (0% return), your account would decline by 3.45%. This fee drag is the single most important factor to evaluate when considering a variable annuity.
Variable Annuity Guarantees
Insurance guarantees are what distinguish a variable annuity from a mutual fund portfolio. These guarantees come in two forms: death benefits (which protect your beneficiaries) and living benefits (which protect you during your lifetime). All guarantees are backed solely by the financial strength and claims-paying ability of the issuing insurance company.
Guaranteed Minimum Death Benefit (GMDB)
The Guaranteed Minimum Death Benefit (GMDB) ensures that if you die before annuitizing, your named beneficiaries will receive at least the greater of your current account value or a guaranteed floor. The standard GMDB guarantees your total premiums minus any withdrawals — meaning your heirs cannot receive less than what you originally invested, even if the market declined significantly.
Enhanced GMDB riders offer more generous guarantees. A highest anniversary value rider locks in your account’s highest value on each contract anniversary as the new death benefit floor. A roll-up rider increases the death benefit base by a set percentage (e.g., 5% per year) regardless of market performance. These enhanced riders cost an additional 0.25–0.75% annually.
The death benefit passes directly to your named beneficiary and avoids probate. However, the earnings portion of the death benefit (the amount exceeding your cost basis) is subject to income tax for the beneficiary.
Guaranteed Lifetime Withdrawal Benefit (GLWB)
The Guaranteed Lifetime Withdrawal Benefit (GLWB) is the most popular living benefit rider and the primary reason many people purchase variable annuities today. A GLWB guarantees that you can withdraw a fixed percentage of a benefit base each year for the rest of your life, even if your actual account value drops to zero due to market losses or sustained withdrawals.
The benefit base is not your account value — it is a separate calculation used solely to determine your guaranteed withdrawal amount. During the deferral period (before you begin withdrawals), the benefit base typically grows at a “roll-up rate” of 5–7% simple or compound per year, regardless of market performance. When you begin taking income, the insurer applies a withdrawal percentage (usually 4–6%, based on your age at first withdrawal) to the benefit base.
If your actual account value performs well and exceeds the roll-up benefit base, most GLWB riders include a “step-up” provision that resets the benefit base to the higher account value. This is how a GLWB can capture market gains while still providing a guaranteed floor.
Guaranteed Minimum Accumulation Benefit (GMAB)
The Guaranteed Minimum Accumulation Benefit (GMAB) guarantees that after a specified waiting period (typically 10 years), your account value will be at least equal to a certain amount — usually your original premium or your premium grown at a modest rate. If the market has not performed well enough for your account to reach that floor, the insurance company makes up the difference.
GMABs are less common than GLWBs and GMDBs but can appeal to investors who are uncomfortable with full market risk. The trade-off is that GMAB riders add cost (typically 0.25–0.75% annually), and the waiting period means you must hold the contract for the full guarantee period to benefit.
How Variable Annuities Are Taxed
The Tax Advantage: Tax-Deferred Growth
All investment gains inside a variable annuity — dividends, interest, and capital gains from subaccount trades — compound tax-deferred. You owe no income tax on any gains until you take money out. In a taxable brokerage account, by contrast, you owe taxes on dividends and realized capital gains every year, even if you reinvest them. Over decades of compounding, this tax deferral can produce a meaningfully larger account balance.
Tax deferral also enables tax-free rebalancing. You can switch between subaccounts — selling equity positions to buy bonds, or vice versa — without triggering a taxable event. In a taxable account, the same rebalancing would generate capital gains taxes.
The Tax Disadvantage: Ordinary Income Treatment
When you eventually withdraw money from a variable annuity, the earnings portion is taxed as ordinary income, not at the more favorable long-term capital gains rate. As of 2026, the top federal long-term capital gains rate is 20%, while the top ordinary income rate is 37%. For a high-income investor, this difference can be substantial.
Variable annuity withdrawals follow a last-in, first-out (LIFO) rule: earnings come out first and are fully taxable. Only after all earnings have been withdrawn do you begin receiving your original premium back tax-free. This is the opposite of how many investors expect it to work and means your first withdrawals are 100% taxable.
Non-Qualified vs. Qualified Variable Annuities
Non-qualified variable annuities are purchased with after-tax dollars (not inside an IRA or 401k). Only the earnings portion is taxed upon withdrawal. Your original premium (cost basis) comes back tax-free.
Qualified variable annuities are purchased inside an IRA, 401(k), or other tax-deferred retirement account. The entire withdrawal — both premium and earnings — is taxed as ordinary income because the original contribution was pre-tax. Note that purchasing a variable annuity inside an IRA provides no additional tax deferral since the IRA itself is already tax-deferred. The only reasons to hold a variable annuity inside an IRA are the death benefit and optional living benefit riders.
Early Withdrawal Penalty
Withdrawals before age 59½ are subject to a 10% IRS early withdrawal penalty on the taxable portion, in addition to ordinary income tax. Limited exceptions apply, including disability, death, and substantially equal periodic payments under IRS Section 72(t). This penalty is separate from any surrender charges the insurance company may impose.
Variable Annuities vs. Alternatives
A variable annuity is not the only way to achieve market exposure, tax deferral, or retirement income. Comparing it against common alternatives helps clarify where a variable annuity genuinely adds value — and where a simpler, lower-cost option may be more appropriate.
| Feature | Variable Annuity | Direct Brokerage | Fixed Indexed Annuity | MYGA |
|---|---|---|---|---|
| Market exposure | Full (up and down) | Full (up and down) | Partial (capped upside, 0% floor) | None (fixed rate) |
| Tax treatment | Tax-deferred; ordinary income on withdrawal | Capital gains/dividends taxed annually | Tax-deferred; ordinary income on withdrawal | Tax-deferred; ordinary income on withdrawal |
| Typical annual fees | 2–3.5% | 0.03–0.5% | 0–1% (may be embedded in caps) | None |
| Principal protection | None (market risk) | None (market risk) | Yes (when held to maturity) | Yes (when held to maturity) |
| Guaranteed income option | Yes (GLWB rider, adds ~1%) | No | Yes (income rider, adds ~1%) | Yes (annuitize or 1035 to SPIA) |
| Death benefit | Yes (standard GMDB) | No (assets pass via estate) | Varies by contract | Yes (account value to beneficiary) |
| Rebalancing | Tax-free | Triggers capital gains | N/A (insurer manages crediting) | N/A (fixed rate) |
| Best for | Tax-deferred market growth + guarantees | Low-cost market growth | Growth with downside protection | Safe, predictable accumulation |
Variable annuity vs. direct brokerage account: For most investors, a low-cost brokerage account with index funds will produce better after-tax results. The variable annuity’s fee drag (2–3.5% annually) and ordinary income treatment on withdrawal typically outweigh the benefit of tax deferral. The exception is an investor who has maxed out all other tax-advantaged accounts and specifically wants the death benefit or guaranteed income features.
Variable annuity vs. fixed indexed annuity (FIA): An FIA provides partial market participation with principal protection — your account never goes negative when held to maturity. If your primary goal is growth with downside protection and you are willing to accept capped upside, an FIA typically delivers a better risk-adjusted outcome at a lower cost. If you want full, uncapped market exposure and are comfortable with the volatility, a variable annuity provides more growth potential.
Variable annuity vs. MYGA: A MYGA offers a guaranteed fixed rate with zero fees and principal protection. It is the simplest, lowest-cost annuity available. If you want predictable, safe growth and do not need market exposure, a MYGA is almost always more efficient. Variable annuities are only preferable if you are seeking equity-level growth potential and are prepared to accept the associated risk and fees.
Who Should (and Shouldn’t) Buy a Variable Annuity
Variable annuities are a niche product that makes sense for a specific profile of investor. Being honest about who they serve well — and who they don’t — is essential to making a sound decision.
- Have already maxed out your 401(k), IRA, HSA, and other tax-advantaged accounts and want additional tax-deferred growth
- Want full market exposure combined with a guaranteed death benefit to protect heirs
- Are a high-income earner with a long time horizon (10+ years before needing income)
- Specifically want a guaranteed lifetime income floor (GLWB) layered on top of a market-based portfolio
- Value tax-free rebalancing between asset classes over a long accumulation period
- Are fee-sensitive — total costs of 2–3.5% annually significantly erode long-term returns
- Do not need additional tax deferral — if your 401(k) and IRA are not yet maxed, use those first
- Are already retired and need predictable income now — a SPIA, FIA with income rider, or MYGA-to-SPIA ladder offers better value
- Have a small balance (under $100,000) — high fees consume a disproportionate share of returns on smaller accounts
- Could achieve the same goal with a low-cost index fund portfolio in a taxable brokerage account
- Don’t understand the product — variable annuity contracts are among the most complex financial products available
The $100,000 Rule of Thumb
Many financial professionals suggest that a variable annuity should only be considered when the allocated amount exceeds $100,000. On smaller balances, the fixed annual fees consume a much larger percentage of returns. A $50,000 variable annuity paying 3% in total annual fees loses $1,500 per year to fees alone — a significant headwind that compounds over time.
The Tax Bracket Question
Tax deferral is most valuable when you expect to be in a lower tax bracket in retirement than you are during your working years. If you are in a high bracket now (32–37%) and expect to drop to 22–24% in retirement, deferring gains inside a variable annuity can produce better after-tax outcomes despite the ordinary income treatment. If you expect to remain in the same or a higher bracket, the capital gains rate advantage of a taxable brokerage account may outweigh the tax deferral benefit.
Variable Annuity Misconceptions
Variable annuities are frequently misunderstood — both by critics who dismiss them entirely and by salespeople who oversell their benefits. Here are the most common misconceptions we encounter:
“Tax deferral makes up for the fees”
This is one of the most common selling points and one of the most misleading. While tax-deferred compounding is genuinely valuable, most academic studies find that variable annuity fees of 2–3%+ more than offset the tax deferral benefit for the majority of investors in most scenarios. The break-even holding period — the number of years you must hold the annuity for tax deferral to overcome the fee drag — is often 15–20+ years, and even then only if you end up in a significantly lower tax bracket at withdrawal. If you are comparing a variable annuity to a low-cost index fund portfolio, the math rarely favors the annuity on a net-of-fee, after-tax basis unless the guarantees provide independent value to you.
“I need a variable annuity for tax-deferred growth”
A variable annuity is not the only way to get tax-deferred market growth. A 401(k), Traditional IRA, Roth IRA, and HSA all offer tax-advantaged growth with significantly lower fees. A variable annuity’s tax deferral makes financial sense only after you have maxed out all other available tax-advantaged accounts. If you still have room in your 401(k) or IRA, those should come first.
“Variable annuities are always bad”
This is the opposite extreme and equally misleading. Variable annuities are frequently criticized in the financial media — often justifiably, because they have been oversold to inappropriate buyers for decades. But for the right person (high income, maxed-out retirement accounts, long time horizon, desire for a death benefit or guaranteed income), a variable annuity can be a legitimate planning tool. The issue is suitability, not the product itself. A variable annuity is wrong for most people, but it is not wrong for everyone.
“The 5% roll-up means I earn 5%”
This misconception causes more disappointment than perhaps any other. The GLWB “roll-up rate” (often 5–7%) is not an investment return. It applies only to the benefit base, which is an accounting figure used to calculate your guaranteed annual withdrawal. You cannot withdraw the benefit base as a lump sum. A $200,000 contract with a 6% roll-up growing to a $320,000 benefit base does not mean you have $320,000. It means the insurer will guarantee you annual withdrawals based on $320,000 (e.g., 5% = $16,000/year for life). Your actual account value may be significantly less.
Already Own a Variable Annuity?
If you currently own a variable annuity, the question is not whether you would buy one today but whether it makes sense to keep the one you have. This is a different analysis that depends on several factors.
When It May Make Sense to Keep It
You are past the surrender period. If surrender charges have expired, you are no longer paying for the privilege of leaving. However, you are still paying annual M&E and management fees. Evaluate whether the ongoing benefits (death benefit, any living benefit rider you elected, tax deferral on accumulated gains) justify the ongoing costs.
You have significant unrealized gains. If your variable annuity has grown substantially, surrendering or exchanging it could trigger a large ordinary income tax bill on those gains. In this case, holding the contract may be more tax-efficient, especially if you plan to use the death benefit (which provides a step-up for calculating the beneficiary’s gain, though earnings are still taxable).
You are using a living benefit rider and it is “in the money.” If you elected a GLWB and your benefit base significantly exceeds your account value (which happens after market downturns), your guaranteed income is worth more than what your account value alone could produce. Surrendering the contract would mean giving up that guaranteed income stream.
When to Consider a 1035 Exchange
A 1035 exchange allows you to transfer the value of one annuity to another without triggering a taxable event. This can make sense if:
Your fees are significantly above market. Older variable annuities sometimes carry M&E charges of 1.5% or higher plus expensive subaccounts. Newer contracts or different product types (such as a low-cost FIA or fee-only variable annuity) may save 1% or more in annual fees. Over 10–20 years, that difference is substantial.
Your investment options are limited or underperforming. Some older contracts offer only a handful of subaccounts with poor track records. Exchanging to a contract with better investment options can improve your long-term returns.
Your needs have changed. If you originally wanted market growth but now prioritize income certainty, a 1035 exchange to a fixed indexed annuity with an income rider or a SPIA may better serve your current goals — with lower fees and less complexity.