Variable annuities: mutual funds inside an insurance contract

A variable annuity holds investment subaccounts, much like mutual funds, inside an insurance contract. It adds tax deferral and optional guarantees. Each layer adds a yearly charge, and every dollar of gain is taxed as income when it comes out.

Education only. We explain how these products work and what they cost. We do not sell or recommend securities.

The numbers

Typical charges, according to regulators

About 1.25%a year, the typical mortality and expense charge, before any fund or rider cost (Missouri Securities Division)

6 to 8 yearsa typical surrender charge period after purchase

No extra benefitfrom tax deferral when the annuity sits inside an IRA or 401(k), which is already tax-deferred

How it is built

The layers of a variable annuity

SubaccountsStock and bond portfolios run by fund managers. Your value rises and falls with them; there is no floor.

Insurance wrapperThe contract adds a basic death benefit and tax deferral, paid for by the mortality and expense charge.

RidersOptional guaranteed income, enhanced death benefit or other features, each with its own yearly fee.

Surrender chargesLeaving in the early years costs a declining percentage. A 1035 exchange avoids tax, not surrender charges, and usually starts a new surrender period.

Tax on the way outGains are taxed as ordinary income, not capital gains, and there is no step-up in basis at death.

The layers add up

$200,000 for 20 years at 7% before costs

Yearly charge (example)	Rate
Mortality and expense charge	1.25%
Administrative fee	0.15%
Subaccount (fund) expenses	0.65%
Optional income or death benefit rider	1.00%
Total	3.05%

Owned as	Value at 20 years
Low-cost index fund, 0.05%	$766,234
Variable annuity with rider, 3.05%	$416,545
Lost to the layers	$349,689

Hypothetical charge levels from typical ranges; actual contracts vary, and rider fees are often charged on a larger benefit base. 7% gross a year, no taxes or surrender charges. Not based on any actual contract.

See also: the same income-rider and tax drag, measured year by year, in Fixed indexed annuities and the Annuity Drag Series →

Case study

Case study coming

A real-world style contract: what each layer cost, and what the same money looked like owned more directly.

If you own one

Questions to ask

What is my total yearly cost: M&E, admin, funds and every rider?
Is the rider fee charged on my account value or a larger benefit base?
When does my surrender period end, and what can I take out free each year?
Is this inside an IRA or 401(k), where deferral adds nothing?
Do I still need the rider, and what do I give up by dropping it?
If someone suggests an exchange, does it start a new surrender period?

Own a variable annuity? Bring the contract, prospectus and latest statement to a product review. We will walk through how it works and every cost inside it. We do not recommend buying, selling or replacing any investment. Schedule a product review → All by-products →

Advanced Capital & Investments pages are for education only. Nothing here is an offer to sell, a solicitation of an offer to buy, or a recommendation of any security or investment strategy, and we do not sell securities through this site. Examples are hypothetical, do not represent any actual product and do not reflect taxes unless stated. Investing involves risk, including loss of principal. Before investing in any fund, read its prospectus and talk with a properly registered professional.