An annuity is a contract with an insurance company where you make contributions (lump sum or periodic payments), the money grows tax-deferred, and the company promises to pay you an income stream in the future — typically in retirement. The two main types differ fundamentally in where the money is invested and who bears the investment risk.
Fixed annuity: Your money goes into the insurance company's general account, and the insurer guarantees a fixed rate of return. The insurance company bears all investment risk. Even if the insurer's portfolio performs poorly, you still receive your guaranteed rate. Fixed annuities are regulated primarily as insurance products — a state insurance license is sufficient to sell them.
Variable annuity: Your money is allocated to subaccounts — investment portfolios similar to mutual funds. Returns fluctuate with subaccount performance. The investor bears the investment risk. Returns could be +15% in a good year or −20% in a bad year. Because variable annuities involve securities risk, they are regulated as both securities and insurance products — a registered representative must hold a Series 6 or Series 7 license AND a state insurance license to sell them.
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This is the defining structural feature of variable annuities.
The separate account holds the assets underlying variable annuity subaccounts. It is legally segregated from the insurance company's general account (which backs fixed annuities and the insurer's own obligations). This segregation is critical: if the insurance company becomes insolvent, the separate account assets cannot be seized by the company's creditors.
Think of it this way: the general account is the insurance company's operating bank account. The separate account is a locked vault that belongs exclusively to variable annuity policyholders. Creditors of the insurance company cannot touch it.
Subaccounts within the separate account function like mutual fund choices. A customer might allocate 60% to a large-cap growth subaccount, 30% to a bond subaccount, and 10% to a money market subaccount. They can typically reallocate among subaccounts without immediate tax consequences — a tax-deferred internal transfer within the contract.
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During the accumulation phase, you are contributing money and it is growing tax-deferred. You own accumulation units — similar to shares in a mutual fund.
Example: You invest $10,000 when a subaccount unit is valued at $10.00, purchasing 1,000 units. If the subaccount appreciates 15%, each unit is now worth $11.50. Your 1,000 units are now worth $11,500 — no tax owed until withdrawal.
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When you annuitize (elect to begin receiving income), your accumulation units are converted to annuity units. The conversion uses an annuity unit value calculated at the time of annuitization.
Key distinction:
So while you know exactly how many annuity units you hold, your monthly payment amount can rise or fall each month based on how the subaccounts perform. This is the "variable" nature of variable annuity payouts.
Summary: Before annuitization → accumulation units (count changes with contributions; value per unit varies). After annuitization → annuity units (count is fixed; dollar payment per unit varies).
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Once you annuitize, you choose a payout structure:
Life only (straight life): Highest monthly payment available. Payments continue for the rest of your life and stop at your death — even if you die one month after annuitization. The insurance company retains any remaining value. Maximum payment; maximum mortality risk.
Life with period certain: Payments guaranteed for your life OR a specified period (e.g., 10 years or 20 years), whichever is longer. If you die in year 3 but selected "life with 10-year period certain," your beneficiaries receive payments for the remaining 7 years. Lower monthly payment than straight life.
Joint and survivor: Covers two lives (typically spouses). Payments continue until both annuitants have died. Often structured as 100% continuation (full payment to survivor) or 50% continuation (reduced payment). The lowest payment option because the insurer expects the longest payout period.
Lump sum: Surrender the contract, take the entire accumulated value in cash. Full tax consequences apply immediately (LIFO rules — see below).
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Variable annuities impose surrender charges (also called CDSC) if you withdraw money within the surrender period — typically 6–8 years from purchase.
Common declining schedule: 7% in year 1, 6% in year 2, 5% in year 3, 4% in year 4, 3% in year 5, 2% in year 6, 1% in year 7, 0% thereafter.
Most contracts allow a free withdrawal provision — typically 10–15% of contract value per year can be withdrawn without surrender charges.
Surrender charges are a major suitability concern. Variable annuities should NOT be recommended to customers who may need access to funds within the surrender period.
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Most variable annuities include a death benefit during the accumulation phase. The standard benefit guarantees the beneficiary receives the greater of:
1. The current account value at the time of death, OR 2. Total premiums paid (minus any prior withdrawals)
Example: Investor deposits $100,000. Markets crash; account value falls to $65,000. Investor dies. The death benefit pays the beneficiary $100,000 (the original premium), not $65,000.
Enhanced death benefits can lock in a step-up value based on the highest past account value — at an additional annual cost.
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Variable annuities are tax-deferred during accumulation. When you withdraw money from a non-qualified (non-retirement account) variable annuity, the IRS applies Last-In-First-Out (LIFO) accounting:
Example: You invested $50,000 (non-qualified). The account grew to $80,000 — $30,000 in gains. You withdraw $10,000. Under LIFO, that $10,000 is entirely earnings → fully taxable as ordinary income.
10% early withdrawal penalty: Withdrawals before age 59½ are subject to both ordinary income tax on the earnings AND a 10% federal penalty — identical to IRA early withdrawal rules.
Key contrast: Qualified annuities (held inside an IRA) follow IRA distribution rules instead.
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Variable annuities are complex, high-cost products. FINRA has issued specific guidance on when they are and are not suitable:
Factors supporting suitability:
Suitability red flags — when a variable annuity is NOT appropriate:
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Quiz Questions:
Q1. An investor annuitized a variable annuity two years ago under a life-only payout option and has been receiving monthly payments. She dies unexpectedly. What happens to the remaining contract value?
A) It is paid to her named beneficiary in a lump sum B) It is paid to her estate over 5 years C) The insurance company retains it; no further payments are made D) Payments continue to her surviving spouse for the remainder of the expected payout period
Answer: C — A life-only (straight life) annuity pays for the life of the annuitant only. When she dies, all payments cease immediately and the insurance company retains any remaining value. This is the tradeoff for receiving the highest monthly payment. Had she selected "life with period certain" or "joint and survivor," payments could continue to beneficiaries or a co-annuitant.
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Q2. During the accumulation phase of a variable annuity, the customer's premium payments are held in:
A) The insurance company's general account, earning a guaranteed rate B) A separate account invested in subaccounts chosen by the policyholder C) FDIC-insured bank accounts maintained by the insurance company D) U.S. Treasury securities until the annuity phase begins
Answer: B — Variable annuity assets are held in a separate account, legally segregated from the insurance company's general account. The policyholder allocates premiums among subaccounts (equity, bond, money market options), and the separate account structure protects assets from insurer insolvency. The general account (A) holds assets for fixed annuities only.
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Q3. A customer invested $70,000 in a non-qualified variable annuity 6 years ago. The account has grown to $110,000. She is now 54 years old and withdraws $25,000. What are the tax consequences?
A) The $25,000 is fully tax-free as a return of principal B) $25,000 is taxable as ordinary income; 10% penalty applies on the full $25,000 C) Only the gain portion ($25,000 / $40,000 × $25,000) is taxable; no penalty D) $25,000 is taxable as long-term capital gains; 10% penalty applies
Answer: B — Using LIFO, earnings come out first. Total earnings = $110,000 − $70,000 = $40,000. Since $25,000 < $40,000, the entire $25,000 withdrawal is classified as earnings and is fully taxable as ordinary income. Because she is under 59½, a 10% early withdrawal penalty also applies to the $25,000. Variable annuity gains are never taxed at capital gains rates (D is wrong) — always ordinary income.
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Q4. Which of the following customers would be LEAST suitable for a variable annuity recommendation?
A) A 48-year-old high-income attorney who has maxed out her 401(k) and IRA and seeks additional tax deferral B) A 40-year-old in the 22% bracket seeking long-term tax-deferred growth for retirement C) A 60-year-old rolling over $150,000 from a traditional IRA directly into a variable annuity held inside a new IRA D) A 52-year-old seeking the death benefit protection feature in case markets decline before retirement
Answer: C — Placing a variable annuity inside an IRA ("wrapping" a VA around an already tax-deferred account) is the classic suitability violation for variable annuities. The IRA already provides tax deferral — adding a VA layers high fees and surrender charges with no additional tax benefit. FINRA has specifically flagged this scenario as unsuitable in most circumstances.
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Q5. During the annuity phase of a variable annuity, an investor holds a fixed number of annuity units. Which statement about monthly payments is MOST accurate?
A) Payments are fixed at the amount set at annuitization and never change B) The number of annuity units increases each month if the subaccounts perform well C) The dollar amount per payment may vary because the value of each annuity unit fluctuates with subaccount performance D) Payments are guaranteed by the insurance company's general account, so they cannot decrease
Answer: C — In the annuity phase, the investor holds a fixed number of annuity units, but the value of each unit fluctuates with the underlying subaccount performance. Therefore, monthly payment amounts can increase or decrease. This is the defining "variable" characteristic of annuity phase payments. Fixed payments (A) describe fixed annuities. The number of annuity units is fixed once annuitization occurs (B is wrong). Subaccount assets are in the separate account — not guaranteed by the general account (D is wrong for variable annuities).