Variable Contracts - Annuity Distributions and Variable Annuity Charges

Withdrawals from an annuity are subject to ordinary income taxes on earnings. A minimum account value is usually required to qualify for certain withdrawal options. The insurance company may also require a minimum distribution amount and will usually allow only a certain number of withdrawals per year.

Withdrawals are deducted from sub-accounts as a percentage based on the proportional amount allocated to each account, unless the policyholder specifies otherwise. For example, if the annuitant has 23% in sub-account X and 77% in sub-account Y, withdrawal amounts will reflect this percentage, albeit at much lesser amounts.

Lump-sum annuity withdrawals are taxed on a last in, first out (LIFO) basis, so earnings are withdrawn first and taxed as ordinary income, while any amount in excess of earnings is taken from the principal amount and is nontaxable. However, annuitized payouts are taxed differently:

  • Each payment is considered to be one part principal (nontaxable) and one part rate of interest (taxable).

  • Each payment is adjusted by an exclusion ratio, which is a ratio that describes the relationship between the invested amount and the total expected return under the annuity contract.

As mentioned earlier, the annuitant can typically transfer money from one investment option to another during the accumulation phase without paying tax on the investment income and gains (although certain insurance companies may charge for the transfers). However, if the investor withdraws money from the account during the early years of the accumulation phase, he or she may have to pay surrender charges (discussed below). In addition, the investor will have to pay a 10% federal tax penalty on earnings if the money is withdrawn before the age of 59.5, unless the withdrawal qualifies for an exemption, such as withdrawals due to death, disability, or those made in substantially equally payments based on the owner's life expectancy.

Variable Annuity Charges
Investors will pay several charges when they invest in a variable annuity. These charges usually reduce the value of the account and the return on the original investment.

Often, they will include the following costs:

  • Surrender Charge: If the investor withdraws money from a variable annuity within a certain period after a purchase payment (typically within six to eight years, but sometimes as long as 10 years), the insurance company will usually assess a type of sales charge known as a "surrender" charge. This charge is used to pay the investment representative's commission for selling the variable annuity. Generally, the surrender charge is a percentage of the amount withdrawn, and it declines gradually over a period of several years, known as the "surrender period".

    For example, a 7% charge might apply in the first year after a purchase payment, 6% in the second year, 5% in the third year, and so on until the eighth year, when the surrender charge no longer applies. Often, contracts will allow the annuitant to withdraw part of the account value each year - 10% or 15% of the account value, for example - without paying a surrender charge.

  • Mortality and Expense Risk Charge: This charge is equal to a certain percentage of the account value, typically in the range of 1-1.25% per year. This charge compensates the insurance company for insurance risks it assumes under the annuity contract. Profit from the mortality and expense risk charge is sometimes used to pay the insurer's costs of selling the variable annuity, such as a commission paid to the investment representative for selling the variable annuity.

  • Administrative Fees: The insurer may charge fees to cover recordkeeping and other administrative expenses. This may be charged as a flat account maintenance fee (perhaps $25 or $30 per year) or as a percentage of the account value (typically in the range of 0.15% per year).

  • Underlying Fund Expenses: These are fees and expenses imposed by the separate accounts that are the underlying investment options in the variable annuity.

Tax-Free "1035" Exchanges
Section 1035 of the U.S. tax code allows the owner of an annuity to exchange an existing variable annuity contract for a new annuity contract without paying any tax on the income and investment gains in the current variable annuity account. These tax-free exchanges, known as 1035 exchanges, can be useful if another annuity has features that an investor prefers, such as a larger death benefit, different annuity payout options or a wider selection of investment choices.

The annuitant may, however, be required to pay surrender charges on the old annuity if he or she is still in the surrender charge period. In addition, a new surrender charge period generally begins when the client switches into the new annuity. This means that, for a significant number of years (as many as 10 years), the client typically will have to pay a surrender charge (which can be as high as 9% of purchase payments) if he or she withdraws funds from the new annuity. Furthermore, the new annuity may have higher annual fees and charges than the old annuity, which will reduce the annuity's returns.

Variable Life Insurance
Related Articles
  1. Economics

    Long-Term Investing Impact of the Paris Attacks

    We share some insights on how the recent terrorist attacks in Paris could impact the economy and markets going forward.
  2. Credit & Loans

    HARP Loan Program: Help for Underwater Mortgages

    If you are underwater on your mortgage, this program may be just what you need to help build up equity in your home.
  3. Taxes

    How & Where to File Form 1040 (And Which Version)

    All taxpayers need to know three things when filing a 1040: which form to use, how to file and where to file. After reading this, you'll know all three.
  4. Stock Analysis

    An Introduction To The Indian Stock Market

    Most trading in the Indian stock market occurs through its two exchanges – the Bombay Stock Exchange and the National Stock Exchange.
  5. Retirement

    Should Social Security Be Privatized?

    The idea of controlling your own retirement money is one that continues to hold appeal for a large segment of voters.
  6. Savings

    How Americans Can Open a Bank Account In Thailand

    Have your paperwork in order and be sure to shop around.
  7. Savings

    Should You Look at 529 Plans Outside Your State?

    529 savings plans are not restricted by geography. So if your in-state offering has high fees or poor investment choices, look elsewhere.
  8. Entrepreneurship

    7 HR Basics for Small Businesses

    Whether or not you are a fan of human resources, every employer needs to know the answers to these questions.
  9. Savings

    Opening a Bank Account in Costa Rica as an American

    It shouldn’t be too hard to do, provided you have the appropriate documentation and forms. But be prepared for lots of paperwork!
  10. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  1. Elastic

    A situation in which the supply and demand for a good or service ...
  2. Earnings Stripping

    Earnings Stripping is a commonly-used tactic by multinationals ...
  3. Skinny Down Distribution

    Skinny down distribution is corporate practice of slimming down ...
  4. Education Loan

    Money borrowed to finance education or school related expenses. ...
  5. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, ...
  6. Student Loan Forgiveness

    Under certain circumstances, federally backed student loans – ...
  1. Are catch-up contributions included in the 415 limit?

    Unlike regular employee deferrals, catch-up contributions are not included in the 415 limit. While there is an annual limit ... Read Full Answer >>
  2. Can catch-up contributions be matched?

    Depending on the terms of your plan, catch-up contributions you make to 401(k)s or other qualified retirement savings plans ... Read Full Answer >>
  3. Is Australia a developed country?

    Australia is one of the most developed countries in the world. The nation's per capita gross domestic product (GDP), one ... Read Full Answer >>
  4. Is Nigeria a developed country?

    Nigeria is not a developed country by any reasonable standard. The country's per capita gross domestic product (GDP) is much ... Read Full Answer >>
  5. Are catch-up contributions included in actual deferral percentage (ADP) testing?

    Though the Internal Revenue Service (IRS) carefully scrutinizes the contributions of highly compensated employees (HCEs) ... Read Full Answer >>
  6. Who offers 401(k) plans?

    401(k) plans are one of the most common retirement plans available. A 401(k) plan must be offered by a business. These plans ... Read Full Answer >>
Hot Definitions
  1. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  2. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  3. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  4. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  5. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
  6. Discount Bond

    A bond that is issued for less than its par (or face) value, or a bond currently trading for less than its par value in the ...
Trading Center