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A variable annuity is a contract between you and an insurance company. You invest money into the annuity, choose from a menu of investment subaccounts (similar to mutual funds), and the account grows tax-deferred. In exchange, the insurance company typically promises certain benefits — such as a death benefit guarantee or a guaranteed lifetime income option.
Variable annuities are one of the most widely sold financial products in the US — and also one of the most debated. They offer real benefits for some investors, but they come with significant fees and complexity that make them wrong for many others.
How a Variable Annuity Works
- You pay a premium. This can be a lump sum or a series of payments, depending on the contract.
- You select subaccounts. The money is invested in subaccounts you choose — typically stock, bond, balanced, or money market funds offered by the insurance company.
- The account grows tax-deferred. You do not pay taxes on gains, dividends, or interest as they accrue. You only owe taxes when you withdraw money.
- At some point, you can “annuitize.” You convert the contract to a stream of income payments — either for a set period or for life. Or you can take withdrawals without annuitizing, which is more common.
The “variable” part means your account value goes up or down with market performance. Unlike a fixed annuity, there is no guaranteed return on your investment.
Accumulation Phase vs. Distribution Phase
Accumulation phase: The period before you start taking income. Your money is invested in subaccounts and grows tax-deferred. You can change your investment allocations, add money, and earn market returns (or losses).
Distribution phase: When you start taking income. You can annuitize (convert to guaranteed lifetime income) or take systematic withdrawals. If you annuitize, the insurance company takes over and pays you based on your balance, age, and the payout option you choose.
Fees: The Main Concern
Variable annuities are famous for high fees. Most have multiple layers:
- Mortality and expense (M&E) fee: The core insurance charge. Typically 1.0%–1.5% of account value per year. Pays for the death benefit and the insurance company’s overhead.
- Administrative fee: Usually $25–$50 per year, or 0.10%–0.25%.
- Subaccount expense ratios: The underlying mutual funds charge their own fees, often 0.50%–1.50% per year.
- Rider fees: If you add optional benefits (a guaranteed lifetime withdrawal benefit, an enhanced death benefit, etc.), expect to pay 0.50%–1.50% per rider per year.
Total annual costs can easily run 2.5%–4.0% per year. That is a significant drag on long-term performance compared to a low-cost index fund portfolio.
Surrender Charges
Most variable annuities have a surrender charge period — typically 5 to 10 years from when you buy the contract. If you withdraw more than the allowed amount (usually 10% per year) during this period, you pay a surrender charge. Surrender charges often start at 7%–8% in year one and step down to zero by the end of the period.
This means your money is not fully liquid for years after purchase. Make sure you will not need the funds before the surrender period ends.
Tax Treatment
- Growth is tax-deferred: You do not pay taxes on dividends, capital gains, or interest inside the annuity.
- Withdrawals are taxed as ordinary income: Unlike a brokerage account where long-term gains are taxed at preferential rates, all annuity withdrawals are taxed as ordinary income. This is a disadvantage if you are in a high bracket.
- LIFO rule: The IRS requires that earnings come out first. The last-in, first-out rule means you pay taxes before you get any return of principal.
- 10% penalty before age 59.5: Same rule as IRAs and 401(k)s. Early withdrawals trigger a 10% penalty plus ordinary income tax.
- No step-up in basis at death: Unlike most other inherited assets, annuities do not get a step-up. Your heirs inherit your cost basis, not the date-of-death value.
Death Benefit
Most variable annuities include a basic death benefit: if you die, your heirs receive at least the amount you paid in (or the current account value, whichever is greater). Some contracts offer enhanced death benefits — such as locking in the highest account value ever reached — but these cost extra.
The death benefit is one reason people buy variable annuities: a floor for heirs even if the market tanks. But for most people, term life insurance is a cheaper way to achieve the same goal.
Guaranteed Lifetime Withdrawal Benefit (GLWB)
The most popular optional rider in recent years is the Guaranteed Lifetime Withdrawal Benefit. With a GLWB, you can withdraw a set percentage of a “benefit base” (often different from your actual account value) each year for life — even if the account runs to zero.
GLWB riders can make sense for retirees who want downside protection and a guaranteed income floor. But they are expensive (typically 0.75%–1.50% per year) and complex. Read the fine print carefully — many GLWB riders restrict investment options, step-down the withdrawal percentage if you pause withdrawals, or have other limitations.
When a Variable Annuity Makes Sense
Variable annuities are not right for most people, but they can make sense if:
- You have maxed out all other tax-deferred accounts (401k, IRA, Roth IRA) and want additional tax-deferred growth
- You are in a high tax bracket now and expect to be in a lower bracket in retirement
- You want a guaranteed lifetime income option and cannot get that elsewhere
- You have a long time horizon (10+ years) that justifies the surrender period and fees
They are a poor fit if you need liquidity, are already in a low tax bracket, are investing inside an IRA (the tax deferral benefit is redundant), or will not hold the annuity long enough for the tax deferral to outweigh the fees.
Variable Annuity vs. Roth IRA
| Feature | Variable Annuity | Roth IRA |
|---|---|---|
| Contribution limits | No limit | $7,000/year ($8,000 if 50+) in 2026 |
| Tax treatment of growth | Tax-deferred (taxed on withdrawal) | Tax-free (qualified withdrawals) |
| Annual fees | 2%–4%+ | None (fund fees only) |
| Guaranteed income option | Available (with rider) | No |
| Required minimum distributions | Yes (at 73) | None during owner’s lifetime |
For most investors, a Roth IRA is a better choice until the contribution limit is reached. The tax-free growth and no RMDs outweigh the annuity’s insurance features for most situations.
For more on retirement income strategies, see our guide on Qualified Longevity Annuity Contracts (QLACs) and our overview of 72(t) distributions for early retirement access.
FAQ
What is a variable annuity?
A variable annuity is an insurance contract where you invest in market-linked subaccounts. Your balance goes up or down with the market. Growth is tax-deferred, and you can add guaranteed income or death benefit riders for extra cost.
What are the fees on a variable annuity?
Total fees typically run 2%–4%+ per year, including mortality and expense charges, fund fees, and optional rider fees.
Is a variable annuity a good investment?
For most people, no. High fees and ordinary income tax treatment on withdrawals make them less efficient than a simple index fund portfolio for most investors. They can make sense if you have maxed out all other tax-deferred accounts and want guaranteed lifetime income.
How are withdrawals taxed?
As ordinary income — not the lower capital gains rate. And withdrawals before 59.5 trigger a 10% penalty on top of income tax.
What is a surrender charge?
A fee for withdrawing more than the allowed amount (usually 10%) during the surrender period, typically the first 5–10 years after purchase. Surrender charges start high (7–8%) and step down to zero over time.
Rates as of May 2026. Variable annuities are complex products. Consult a fee-only financial advisor before purchasing.