For starters, a variable annuity is a long-term financial contract that can be purchased through single, or multiple, premium deposit(s).

Riders and benefits

These annuities can be purchased with or without an income rider. Paying an additional fee for an income rider can often guarantee income for life for the annuitant, with a survivor’s benefit in a joint contract to the spouse. Without the income rider added at the time of purchase, the variable annuity lifetime income for the annuitant is limited to annuitization with no spousal death benefit.

In the case of a jointly-owned annuity with a spouse, free withdrawals are available for both the annuitant and spouse as long as the annuity has funds in the accumulated account and contract terms are adhered to. Mutual-fund allocation choices made by the annuitant and their performance will affect the value of the guaranteed withdrawal balance (The guaranteed withdrawal balance is only used to calculate the guaranteed withdrawal amount and cannot be surrendered as a cash value). Many insurance companies also offer a guaranteed minimum that offers an increase at a pre-determined time if the market value of the fund allocations has not been greater than the interest guarantee.

The income rider balance can be recalculated for growth. Principal growth in the variable annuity income rider and account value can be accomplished by allocating fund choices available in the annuity contract. The mutual funds’ performance within the variable annuity is directly affected by the market, positive or negative. If the income rider isn’t added at the time of purchase, the variable annuity is solely attached to the market’s positive or negative moves. With the income rider added at the time of purchase, the annual recalculation of the rider value can be locked in.

It’s important to note that the income rider in a variable annuity typically has an expense fee that is greater than the rider in the indexed annuity. The income rider with a variable annuity can also come with a bonus offered by the insurance company. I have personally seen this bonus vary from 5% to 7%, depending upon the insurance company. The “bonus feature” is added to the income rider benefit base.

Let’s look at a hypothetical example: a $100,000 premium deposit receiving a 5% bonus will have an income base of $105,000. This value is used to calculate the income to the annuitant using the percentage payout. The income rider bonus can apply to both index and variable annuity contracts with insurance companies.

In addition to income riders, there are also death benefit riders available with some variable annuities.

Hypothetical example: You own a variable annuity that offers a death benefit equal to the greater of account value or total of purchase payments minus withdrawals. You have contributed $200,000. In addition, you have withdrawn $40,000 from your account. Because of these withdrawals and investment losses, your account value is currently $150,000. If you die, your designated beneficiary will receive $160,000 (The $200,000 purchase payment you put in minus the $40,000 of withdrawals.)

It’s strongly advised to anyone considering the purchase of a variable annuity to speak with your advisor to understand its parts and features.

Roth conversions

It may be worth examining a Roth conversion strategy through the purchase of a qualified variable annuity. Examining the tax implications of doing a Roth conversion from a traditional IRA as early as possible has a strong possibility of locking in the cost of taxes paid for the conversion. Tax schedules and tax brackets can change in the future and could be more expensive.

Variable and index annuities: how they compare

Both variable and index annuities can be used for qualified (IRA, 401(k), etc.), and non-qualified (after-tax) money.

An advantage of using an annuity for non-qualified money is its tax-deferred accumulation feature. After a purchaser deposits into a non-qualified annuity with after-tax money, the earnings going forward in the contract are tax-deferred until income distribution, which is taxed as ordinary income at current tax rates. A qualified annuity, variable or indexed, can take advantage of 72(t) tax income distribution prior to 59 ½ without the 10% penalty.

A non-qualified variable or indexed annuity can take advantage of 72(q) income distribution before 59 ½ without the 10% penalty as well. Both types of annuity contracts have the advantage of accumulating tax-deferred. As mentioned in part one, the variable annuity also has a percentage payout calculation. The same rules and strategies apply, as mentioned in the article part one.

When considering if either an index or variable annuity could your portfolio, keep the following facts in mind:

1. An index annuity typically has fees lower than a variable annuity
2. A variable annuity can offer more upside growth potential in a good market year as compared to an index annuity.
3. An index annuity has less downside market risk in a bad market year than a variable annuity.

Both variable and index annuities can serve an investor well. The purchaser of either of these annuities needs to understand their circumstances and goals to be matched with the parts and features of the annuity of choice. Speak with an experienced financial professional to discover what could work for you.

Courtesy of Forbes

Written by Bob David, Impact Partners