Variable Annuitization: What It is, How it Works

What Is Variable Annuitization?

Variable Annuitization is an annuity option where the income payments received by the policyholder vary according to the investment performance of the annuity. It is one option that can be selected by the policyholder during the annuitization phase of a contract, where the policyholder exchanges the accumulated value of the annuity for a stream of regular income payments guaranteed for life or a specified number of years.

Key Takeaways

• During the accumulation phase of an annuity, an investor adds funds, and the earnings grow tax-deferred.
• When the policyholder is ready to start cashing out, they can choose to make withdrawals or annuitize the contract.
• If the policyholder chooses to annuitize the contract, they will choose either fixed or variable payments.
• A variable annuity is just like it sounds—variable. The payments are based on the performance of the annuity’s assets.
• There is more profit potential with a variable annuity. However, during market downturns, payments will be lower than an annuity with a fixed rate.

Understanding Variable Annuitization

There are two phases to the life of an annuity. During the accumulation phase, an investor adds funds to the annuity, with all earnings exempt from current income tax. Once a policyholder is ready to start receiving income, they can choose to make withdrawals or annuitize the contract and elect fixed or variable payments.

During the annuitization phase, for annuities purchased with after-tax dollars, a fixed amount of each payment is treated as a non-taxable return of the original basis, and the balance is taxed as income. Alternatively, all annuity income received through withdrawals is generally taxed as income until all the earnings have been withdrawn.

After all earnings have been withdrawn, withdrawals are non-taxable returns of the original (already taxed) investment in the annuity. For annuities purchased with pre-tax dollars, all income—whether via annuitization or withdrawals—is fully taxable as ordinary income.

Variable Annuity Considerations

Choosing how to receive payments from an annuity can be difficult for investors and often comes down to the amount of risk the policyholder is willing to take compared with the returns they want.

Choosing fixed annuitization means the policyholder will receive the same amount of money in each periodic annuity income payment over the life of the annuity, regardless of how the annuity company’s portfolio performs. In contrast, variable annuity payments vary over time because they are based on the performance of an underlying portfolio.

According to the Financial Industry Regulatory Authority (FINRA), "Variable annuities are highly complex financial products" with multiple insurance features that come with fees and charges. They require careful consideration.

Considerations include the duration of tying up money, surrender charges or other penalties for early withdrawal, the financial benefit or commission for selling the annuity, the risk of investment loss, and expected fees and expenses.

Annuity purchases provide income security but may lock funds into an underperforming product. Professionals selling annuities typically receive a commission based on the type and value of the annuity sold. Variable annuity values are tied to the performance of selected sub-accounts, which are mutual fund-like instruments.