Understanding Annuities: Fixed Annuities vs. Variable Annuities

With annuities, it's important to know what you're getting into. This is a huge decision that'll determine how much and how often you get paid during your retirement years. Should you go with a fixed annuity or a variable annuity? Let's take a look at some of the differences between fixed annuities and variable annuities, and you can decide which one sounds more along the lines of what you're looking to do with your money.

What Are They?

First things first, let's define them. A fixed annuity is a contract offered by an insurance company. You deposit money and the insurer agrees to pay a certain interest rate over a specified period of time. A variable annuity is an insurance contract that, at the end of the accumulation stage, the insurance company guarantees a minimum payment. The rest of the income payments can vary depending on the performance of the managed portfolio.

Essentially, variable accounts are similar to mutual funds. You can invest in one or more accounts, and those accounts can own stocks, bonds, or a combination of both. Variable annuities have more fees than mutual funds, though, which leads to them having a higher annual operating expense than mutual funds.

The Tax Differences

One important difference between fixed annuities and variable annuities is the way that they're taxed. With both fixed and variable annuities, any earnings remain untaxed as long as they within their annuity. However, if they're withdrawn, the earnings are taxed like normal income. If you draw before the age of 59, you'll pay a 10 percent penalty.

The earnings in your variable annuity are taxed at ordinary income rates instead of long-term capital gains rates. This essentially converts all long-term capital gains to ordinary income, which is a definite disadvantage for variable annuities because it boosts the share of your gains that go to the government. If you pull your money out within the first seven to 10 years, you'll have to pay an early withdrawal penalty. You may need to calculate different types of annuities to see which one works best for you.

The Safety Difference

A fixed annuity offers more security than a variable annuity, but the upside potential is very limited. With variable annuities, you accept more short-term volatility because the value of your investment will fluctuate with the value of the stock and bond markets. You're essentially looking at risk versus return.

With a variable annuity, if the market goes up, you're golden; if it goes down, you lose money. Fixed annuities are also based on the market, but they don't directly participate in it. The interest is paid out at certain intervals based on how well a specific measure of the market is performing.

Rather than just offering a guarantee, variable annuities provide the opportunity for growth. Your return will depend entirely on how well the investment you select does, and may be greater or less than that of a fixed annuity. If you die before you begin receiving annuity payments, your heirs will receive at least as much as the total of your premium payments.

The Hidden Costs

Fixed annuities don't usually have hidden fees. If they do have a fee, it'll be an annual policy fee, which could run $25 to $50 annually, which can be waived if your investment meets a minimum specified amount. Variable annuities, however, have a ton of hidden fees and charges. They have mortality and expense risk charges, administrative fees, sales and surrender charges, and charges for optional benefits and riders.

It basically comes down to risk tolerance and how much control you want over the investment decisions. Fixed annuities have very little risk, but there's no growth potential. Variable annuities provide a much greater potential for growth, but there's a huge risk involved. Your investment decisions can impact the growth of the annuity. There's a lot of management involved with a variable annuity as well.

For a steady stream of income after retirement, a fixed annuity is the way to go. With little risk and a guaranteed minimum return, you know exactly how much you're getting. Variable returns are much riskier and nothing is really guaranteed; you shouldn't rely on variable annuities as a source of income. Sure, your investment could pay off big time, but you could be left without a retirement fund. If you've got the extra money, a variable annuity might be a fun venture, but otherwise, a fixed annuity seems like a much safer option.

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