Variable annuities allow the owner considerable flexibility to invest annuity premiums in any way they see fit. The risks involved are the same as investments in stocks, bonds or mutual funds. The investor gets to keep the entire profit from gains and is liable to bear the loss for any decline in the price of invested holdings.
So what is the difference here? The difference is that variable annuities are stock market investments with all the trappings of an insurance policy. All contributions and gains in a variable annuity are tax deferred. Annuities are often protected from creditors. If you are a professional in a sector with a high potential for malpractice suits or other economic hazards, then annuities can help provide a sheltered savings tool.
The key issue when it comes to annuities is that once you choose to annuitize the contract, the decision is final. You pay a lump sum amount to the insurance company and in return, the company agrees to pay you a fixed monthly amount for the rest of your life. Now the question of who makes a profit here depends on how long you live. If you live for the next 20-30 years, it is quite possible that you end up getting more than what you paid in. If, however, you pass away within a short period after annuitizing the contract, that leaves the company holding the balance of the huge amount you paid in.
Investments in annuities are tied up until age 59 ½ , and early withdrawals are subject to a 10% penalty by the IRS. Also, investment gains are taxed upon withdrawal at ordinary income tax rates, instead of long term capital gains tax. Some companies will also charge surrender fees, if you wish to change your annuity to another company. The fee will vary depending on the age of the annuity. Administrative changes and annual fees are buried into the cost of the contract and will be deducted from your profit. These charges average around 1.4%, but can be as high as 2.5%.
Variable annuities have a lot of advantages over direct investments in stock markets, but also have their downsides. It is necessary to take a good look at how annuities work, what are the hidden charges, how much flexibility you really have and what are the long term gains. It is advisable to discuss your options with a financial advisor.