Variable annuities: how they work, what they cost, who they suit

A variable annuity is an insurance contract whose value is invested in subaccounts, which work much like mutual funds, so what you have depends on market performance and can fall. It adds insurance features such as a death benefit and optional lifetime income riders, and defers tax on earnings. It also carries some of the highest fees among annuities. Because you bear investment risk, variable annuities are securities regulated by the SEC and FINRA as well as by state insurance departments.

How it works

You pay a premium, either all at once or over time, and allocate it among subaccounts such as stock, bond and balanced portfolios offered by the contract. The value moves with those investments. The SEC's Updated Investor Bulletin: Variable Annuities (October 30, 2018) describes the contract as an investment account that may grow tax-deferred and includes insurance features, such as a death benefit and the ability to turn the account into periodic payments.

A variable annuity has two phases. In accumulation, you invest and may move money among subaccounts without current tax. In the payout phase you can take withdrawals or annuitize into income, which may be fixed or variable. A deferred contract is the norm; see deferred annuity.

The layers of cost

Costs are the main reason variable annuities are contested. The SEC bulletin warns that fees and expenses may be significant and can include surrender charges and ongoing charges. Typical layers:

Add them up. A contract whose M&E, administrative, fund and rider charges combine to a few percent a year can erase much of the benefit of tax deferral over time. Ask for the total annual cost in dollars on your intended amount. annuity fees, explained goes into this in detail. Some newer or no-load contracts, often sold through fee-only advisors, charge less and have no surrender charges; the lower-cost versions are worth comparing.

Riders and guarantees

A common rider is a guaranteed lifetime withdrawal benefit; see guaranteed lifetime withdrawal benefit riders. It typically guarantees a percentage withdrawal of a "benefit base" for life even if the account value drops to zero. The benefit base is usually not a cash amount you can withdraw, and the rider has an annual charge, investment restrictions and rules about how withdrawals reduce it. Death benefits may guarantee at least your premiums back, less withdrawals.

These guarantees are promises of the insurer and are backed by its claims-paying ability, not by the market. The subaccount assets are held in a separate account, apart from the insurer's general assets, but the guarantees rely on the general account. The state guaranty association provides limited protection if the insurer fails; according to NOLHGA (as of June 1, 2025), most states cover $250,000 of annuity present value. Use the state guaranty association coverage lookup.

Taxes

Earnings are tax-deferred and taxed as ordinary income when withdrawn, not at capital-gains rates, and distributions before age 59 1/2 can carry a 10% additional tax unless an exception applies (IRS Topic 410). Held in an IRA or 401(k), a variable annuity gives no extra deferral; you would be paying insurance-contract fees for deferral the account already provides, a question taken up in Should you put an annuity in an IRA?. Heirs generally owe tax on the gain; see what happens to an annuity when you die.

Securities rules that protect you

Variable annuities are registered with the SEC, which means a prospectus. Since 2020 issuers may use a summary prospectus under SEC Rule 498A, which gives key facts in a shorter document. Sellers must be licensed with FINRA and held to suitability and best-interest standards; FINRA Rule 2320 specifically governs variable contracts. See best interest rules for annuity sales. Read the prospectus fee table before signing, and use the free-look window. Exchanges from one annuity to another can be tax-free but can restart surrender periods; the SEC has also published an investor bulletin on whether to accept a buyout offer on a variable annuity, which is worth reading before giving up existing guarantees.

A hypothetical comparison

Say a 55-year-old puts $200,000 into a variable annuity with combined annual charges of 2.5% and a ten-year surrender schedule, versus a low-cost index fund at 0.1% in an IRA or taxable account. At 2.5% a year the annuity costs $5,000 in year one, versus $200. The annuity must earn more, or the guarantee must be valuable, to come out ahead. The tax deferral helps most when the investor has maxed out other accounts. This is a simple illustration of fee drag, not a prediction.

Who it suits, and who it doesn't

Often suits:

• High earners who have used 401(k)s and IRAs and want more tax deferral and a lifetime-income guarantee while keeping market exposure.
• Savers who value a guaranteed income floor and understand the rider's cost and limits.

Often does not suit:

• Anyone who has not exhausted lower-cost tax-advantaged accounts.
• Investors who want low costs and flexibility; index funds are much cheaper.
• Money in an IRA bought solely for tax deferral.
• Buyers who cannot explain the fee layers or who need access in the first several years.

Key takeaways

• A variable annuity invests in subaccounts, so you carry the market risk; it is a security regulated by the SEC and FINRA.
• Fee layers (M&E, administration, funds, riders) can total several percent a year; ask for the all-in cost.
• Guarantee riders depend on the insurer's strength and have conditions that limit what you can access.
• Extra tax deferral is mainly useful after you have used your 401(k) and IRA room.
• Compare with low-cost investments and read the prospectus before committing.