AIR Variable Annuity: Taxes, Fees, and Withdrawal Options

A variable annuity’s taxes, fees, and payouts work together in ways that decide whether the contract actually pays off for you. Money inside the contract grows tax-deferred, but every dollar of earnings comes out as ordinary income, and a withdrawal before age 59½ usually adds a 10% federal penalty on top. Annual costs commonly run 2.5% to 3.5% of the contract value once you stack the insurance charge, administrative fees, subaccount expenses, and any riders. When you take the money, you can draw it down piecemeal, cash it all out, or annuitize it into a guaranteed income stream, and each route is taxed differently.

How Taxes Work While the Money Grows

Inside the contract, you pay no annual tax on dividends, interest, or capital gains, and you can move money between subaccounts without triggering a taxable event.¹ That deferral is the product’s main selling point.

The tradeoff arrives on the way out. Gains that would have qualified for long-term capital gains rates (topping out at 20% for most taxpayers) in a taxable brokerage account are taxed at ordinary income rates as high as 37% when withdrawn from a variable annuity. The deferral has to compound long enough to outrun that rate disadvantage, which is why short holding periods rarely make sense.

One boundary worth clearing up before going further: if the annuity sits inside an IRA, 401(k), or 403(b), the retirement account itself already provides tax deferral. Wrapping a variable annuity inside it adds insurance charges without adding any tax benefit. That combination only makes sense if you specifically want the annuity’s insurance features and have decided they justify the extra cost.

How Withdrawals Are Taxed

For non-qualified variable annuities (those bought with after-tax money outside a retirement account), the IRS applies an earnings-first rule. Any withdrawal you take before annuitizing is treated as coming from investment gains first. Every dollar is fully taxable as ordinary income until all earnings are exhausted, and only then do withdrawals become a tax-free return of your original contributions.² This is the opposite of how cost-basis recovery works in a taxable brokerage account.

For a qualified annuity, contributions went in pre-tax, so the entire distribution is taxed as ordinary income when you take it out.

The insurer reports every distribution on IRS Form 1099-R, which breaks out the taxable and non-taxable portions for your return.³

The 10% Early Withdrawal Penalty

Pull money out before age 59½ and the IRS generally imposes a 10% additional tax on the taxable portion. The penalty applies to both qualified and non-qualified annuities and stacks on top of the ordinary income tax you already owe.⁴

Several exceptions let you avoid the penalty:

Distributions to a beneficiary after the owner’s death, or to the owner after becoming totally disabled.⁵
Substantially equal periodic payments, or SEPPs, based on your life expectancy. Once started, the payments must continue for at least five years or until you reach 59½, whichever is later. Stopping early triggers retroactive penalties on all prior distributions.⁵
Withdrawals by victims of domestic abuse, up to the lesser of $10,000 or 50% of the account balance.⁶
One emergency personal expense distribution per calendar year of up to $1,000 (or the vested balance above $1,000, if less).⁶

Qualified annuities held in employer plans may qualify for additional exceptions, such as separation from service at age 55 or older. Check the specific rules for your plan type.

The 3.8% Net Investment Income Tax

Higher earners face a second tax layer on non-qualified annuity withdrawals. The 3.8% Net Investment Income Tax applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married filing jointly.⁷ Those thresholds are fixed by statute and are not adjusted for inflation, so more taxpayers cross them each year. Annuity income from non-qualified contracts counts as net investment income for this purpose.⁸

Distributions from qualified plans, including qualified variable annuities held inside a 401(k), 403(b), IRA, or 457(b), are specifically excluded from the NIIT.⁸

What Happens at Death

Variable annuities carry a guaranteed minimum death benefit: if you die before taking income, your beneficiary receives at least the total purchase payments you put in, even if the market has fallen.¹ That guarantee protects principal but does not shield the earnings from income tax.

For a non-qualified annuity, the beneficiary owes ordinary income tax on the earnings portion of the death benefit; the original contributions come back tax-free. For a qualified annuity, the entire distribution is taxable.

Spousal Beneficiaries

A surviving spouse can elect to continue the contract as the new owner, preserving tax deferral until they begin taking withdrawals. No other beneficiary has this option. A spouse can also take a lump sum or annuitize, but continuation is generally the most tax-efficient choice if the money isn’t needed immediately.

Non-Spouse Beneficiaries

For qualified annuities held in IRAs or employer plans, the SECURE Act generally requires most non-spouse designated beneficiaries to empty the account by the end of the 10th year following the owner’s death.⁹ Eligible designated beneficiaries (minor children, disabled individuals, and beneficiaries not more than 10 years younger than the deceased owner) may stretch distributions over their own life expectancy.

For non-qualified annuities, IRC Section 72(s) generally requires full distribution within five years of the owner’s death. An exception applies if the beneficiary begins receiving payments within one year of death and stretches them over their own life expectancy. Either way, all earnings are taxed as ordinary income when received.

What a Variable Annuity Costs Each Year

Variable annuities are among the most expensive retail investment products. Fee layers stack, and the total drag on returns is easy to underestimate because no single item looks outrageous.

Mortality and Expense Risk Charge

The mortality and expense (M&E) charge pays for the insurance wrapper, covering the death benefit guarantee and the insurer’s administrative profit margin. It typically runs between 0.40% and 1.75% of the contract value per year, deducted automatically.

Administrative Fees

Separate administrative fees cover recordkeeping and contract maintenance. They may be charged as a small annual percentage or as a flat dollar fee, often $25 to $50 per year. Many insurers waive the flat fee once the contract value exceeds a threshold.

Subaccount Expense Ratios

Each subaccount charges its own expense ratio, generally 0.25% to 1.0% annually, deducted from the fund’s assets before returns reach you. You pay these on top of the M&E and administrative charges.

Surrender Charges

Surrender charges penalize early exits. If you withdraw more than the penalty-free allowance or liquidate the contract during the surrender period, the insurer deducts a percentage from the withdrawn amount. Surrender periods typically last five to eight years, with charges starting at 5% to 8% in year one and declining by roughly one percentage point per year. Most contracts let you withdraw up to 10% of the contract value each year without a surrender charge; some allow less.

Optional Rider Fees

Riders for guaranteed lifetime income, enhanced death benefits, or other features add their own annual percentage charges, commonly 0.25% to over 1.0% each.

Total Cost

Stack M&E, administrative fees, subaccount expenses, and one or two riders, and total annual costs easily exceed 2.5% to 3.5% of the contract value. The SEC requires insurers to disclose all these fees in a standardized fee table in the prospectus.¹⁰ A 3% annual drag means your investments need to return 3% just to break even, before the tax bite on withdrawal.

How to Take the Money Out

Once you’re ready to draw on the contract, you have three basic routes, and the tax treatment differs for each.

Systematic Withdrawals

You take periodic payments while the balance stays invested. Market exposure continues, and you can adjust the amount. The earnings-first rule applies: each withdrawal is fully taxable until all gains are exhausted.²

Lump-Sum Withdrawal

Cashing out triggers immediate ordinary income tax on all accumulated earnings. If the contract is still in the surrender period, you’ll also pay a surrender charge. A large lump sum can push you into a higher tax bracket and may trigger or increase your exposure to the 3.8% Net Investment Income Tax. It’s rarely the most tax-efficient choice.

Annuitization

Annuitization converts your accumulated value into a guaranteed stream of payments, typically for life. Once you annuitize, the decision is irrevocable. The insurer calculates the payment based on the contract value, your life expectancy, and a guaranteed interest rate.

The tax treatment is more favorable than systematic withdrawals. The IRS uses an exclusion ratio to split each payment into a taxable portion (earnings) and a tax-free portion (return of your original investment). The ratio equals your investment in the contract divided by the total expected return.⁴ If you invested $200,000 and the expected return is $400,000, the exclusion ratio is 50%, so half of each payment comes back tax-free. Once you’ve recovered your full investment, all subsequent payments are fully taxable.¹¹

Common annuitization structures include life-only payments (highest payout, nothing left for heirs), life with a period certain (payments continue to a beneficiary if you die within a guaranteed period such as 10 or 20 years), and joint-and-survivor payments (a reduced payment that continues to a surviving spouse).

Switching Contracts Without a Tax Bill

If you’re unhappy with your annuity’s performance, fees, or investment options, you don’t have to cash out and take the tax hit. Under IRC Section 1035, you can exchange one annuity contract for another without recognizing gain or loss.¹² The same provision allows an exchange for a qualified long-term care insurance policy.

The exchange must go directly between insurers. If the old insurer sends you a check that you then deposit with a new insurer, the IRS treats it as a taxable distribution followed by a new purchase, and you’ll owe tax on all accumulated earnings.¹³ Partial exchanges are allowed, but no withdrawals (other than annuity payments over 10 years or more, or over a lifetime) can be taken from either the old or new contract within 180 days of the transfer.

Before executing an exchange, compare surrender charges on the old contract with the terms of the new one. A new contract means a new surrender period, and you might be trading one set of penalties for another. FINRA requires brokers to evaluate whether an exchange makes economic sense given the surrender charges and lost benefits involved.¹⁴

Protections Before and After You Buy

Variable annuities are securities registered with the SEC and sold by licensed broker-dealers, which brings regulatory protections that don’t exist for simpler insurance products.

FINRA Suitability Rules

FINRA Rule 2330 requires the broker recommending a variable annuity to gather detailed information about your age, income, investment experience, risk tolerance, time horizon, existing assets, and liquidity needs before making a recommendation. The broker must have a reasonable basis to believe you’ll benefit from the annuity’s specific features, such as tax deferral, a death benefit, or a living benefit rider.¹⁴ For exchanges, the broker must also evaluate whether you’d lose benefits, incur surrender charges, or restart a surrender period. A registered principal must review and approve the application before it goes to the insurance company.

Free-Look Period

After you receive your contract, you typically have a free-look period of 10 or more days to cancel for a full refund of purchase payments without paying surrender charges. The refund may be adjusted for market performance and charges during the look period. The exact duration varies by state; check your contract.

State Guaranty Associations

If the issuing insurer becomes insolvent, state guaranty associations provide a backstop. In most states, annuity coverage is capped at $250,000 in present value of annuity benefits per owner. A handful of states offer higher limits, up to $500,000.¹⁵ This is not FDIC insurance and is funded by assessments on other insurers in the state, not by a government guarantee. Checking the financial strength ratings of the issuing insurer before buying is worth the few minutes it takes.

1
U.S. Securities and Exchange Commission. Variable Annuities: What You Should Know
2
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
3
Internal Revenue Service. About Form 1099-R
4
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
5
Internal Revenue Service. Substantially Equal Periodic Payments
6
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
7
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
8
Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
9
Internal Revenue Service. Retirement Topics – Beneficiary
10
U.S. Securities and Exchange Commission. Disclosure of Costs and Expenses by Insurance Company Separate Accounts
11
Internal Revenue Service. Publication 939 – General Rule for Pensions and Annuities
12
Office of the Law Revision Counsel. 26 U.S. Code 1035 – Certain Exchanges of Insurance Policies
13
Internal Revenue Service. Revenue Ruling 2007-24
14
FINRA. 2330. Members’ Responsibilities Regarding Deferred Variable Annuity Transactions
15
NOLHGA. How You’re Protected