What Is a Variable Annuity? How It Works, Fees, and Taxes

A variable annuity is a tax-deferred contract issued by an insurance company that lets you invest premiums in market-based sub-accounts and postpone taxes on any growth until you take money out. The value of the contract rises and falls with the markets, so you carry the investment risk in exchange for higher return potential than a fixed annuity would offer. These contracts are built for long-term retirement saving, and the fee structure is layered enough that understanding costs matters as much as understanding tax benefits.

How the Contract Is Structured

A variable annuity involves a few defined roles. The insurance company issues the contract and manages the investment platform. The owner buys the contract, chooses the investments, and names the beneficiaries. The annuitant is the person whose life expectancy the insurer uses to calculate future payouts. Owner and annuitant are usually the same person, though the contract allows them to differ.

Your premiums go into a “separate account” that the insurer maintains apart from its corporate assets. That structure legally shields your money from the insurer’s general creditors. Inside the separate account, you allocate premiums across a menu of sub-accounts that function much like mutual funds, with exposure to stocks, bonds, and money market instruments. You don’t technically own shares of those sub-accounts. Instead, the insurer credits you with accumulation units representing your proportional interest, and the unit value moves daily with the underlying investments.

Because variable annuities are considered securities, they must be registered with the SEC, and anyone selling them needs a FINRA license in addition to a state insurance license.¹

What a Variable Annuity Costs

Variable annuities are among the most expensive investment vehicles you can own. Total annual costs on a typical contract with an income guarantee run around 3.3%. Contracts without optional riders cost less. Because fees compound against your balance every year, even small differences meaningfully erode long-term returns.

The main fees stack on top of each other:

Mortality and expense risk charge (M&E), which compensates the insurer for the mortality risk it assumes through the death benefit and other guarantees. This typically runs between 0.20% and 1.80% of account value per year, assessed daily.
Sub-account management fees, comparable to the expense ratio on a mutual fund, generally adding another 0.5% to 1.0% or more annually.
Administrative fees covering recordkeeping and contract maintenance, usually under 0.30% per year.
Optional rider fees for guaranteed income or enhanced death benefits, adding 0.30% to 2.50% annually depending on the guarantee.

No single charge looks devastating on its own. The problem is the total. An owner paying 1.2% in M&E, 0.8% in sub-account fees, 0.2% in administrative costs, and 1.0% for an income rider is giving up 3.2% every year before the investments earn a dime.

Getting Money Out

Variable annuities are designed to be held for the long haul, and the surrender charge schedule enforces that. If you withdraw more than a specified amount during the surrender period, the insurer deducts a penalty from the withdrawal. Surrender periods typically last six to ten years, with the penalty starting between 5% and 8% and declining by about one percentage point each year until it reaches zero.²

Most contracts let you take out a portion of your account each year without triggering the charge. A common allowance is 10% of contract value annually.¹ Anything above that during the surrender period gets hit with the applicable penalty. Each new premium payment may start its own surrender clock, so a contract that has been open for years can still have recent contributions locked under a full charge schedule.

This is where buyers most often get burned. Someone purchases the contract, realizes a year or two later that the fees are higher than expected or the investment menu is thin, and finds they’ll lose 6% or 7% of their balance to exit. Before committing, be sure you can leave the money untouched for the entire surrender period.

Every state also mandates a free-look period after purchase, typically 10 to 30 days. During this window you can cancel the contract and get a full refund of your premiums with no surrender charges. The exact length varies by state, but the protection exists everywhere. Second thoughts belong inside this window.

Payout Options When You Retire

When you’re ready to convert your accumulated value into income, the contract enters the annuitization phase. Your accumulation units are exchanged for annuity units, and the insurer begins periodic payments. The amount depends on your age, the value you have built up, and the payout structure you choose:

Life only, where payments continue for the rest of your life. This produces the highest monthly amount, but payments stop when you die, leaving nothing for heirs.
Joint and last survivor, where payments continue until the second of two named people dies. The monthly amount is lower because the insurer expects to pay longer.
Period certain, where payments are guaranteed for a fixed number of years, typically five to twenty, regardless of whether you’re alive. If you die during the period, your beneficiary receives the remaining payments.
Life with period certain, which combines a lifetime guarantee with a minimum payout period. If you die before the guaranteed period ends, your beneficiary receives payments for the remainder.

Under a variable payout, the number of annuity units you hold stays constant, but the dollar value of each unit moves with market performance. Strong returns increase your payments; weak returns reduce them. Some contracts let you lock in a fixed payment instead if predictability matters more than upside.

How Variable Annuities Are Taxed

The tax rules for variable annuities flow from Internal Revenue Code Section 72. The core benefit is straightforward: investments grow tax-deferred. Dividends, interest, and capital gains generated inside the sub-accounts are not taxed in the year they occur.³ Taxes come due when you take money out, and the treatment depends on whether the annuity is qualified or nonqualified.

Qualified vs. Nonqualified

A qualified variable annuity is purchased inside a tax-advantaged retirement account such as an IRA or 401(k). Because the premiums were paid with pre-tax dollars, every dollar you withdraw is taxable as ordinary income. Nothing comes back tax-free.

A nonqualified variable annuity is purchased with after-tax money outside of a retirement account. You’ve already paid tax on your premiums, so only the earnings portion of each withdrawal is taxable. Original contributions come back tax-free. A $200,000 lump-sum withdrawal from a qualified annuity is fully taxable. The same withdrawal from a nonqualified annuity where you contributed $120,000 would only be taxed on $80,000 of gain.

Withdrawals Before Annuitization

If you take withdrawals from a nonqualified variable annuity before converting it to an income stream, the IRS treats your earnings as coming out first. Under Section 72(e), each withdrawal is allocated to gain on the contract up to the total gain, and only after all earnings have been withdrawn do you start receiving a tax-free return of premiums.³ Financial professionals call this the earnings-first or LIFO rule. Early withdrawals are usually 100% taxable until you’ve pulled out all the growth. For qualified annuities held in an IRA, this distinction doesn’t matter because the entire withdrawal is taxable anyway.

The 10% Early Withdrawal Penalty

Take money out of a variable annuity before age 59½ and the IRS imposes an additional 10% tax on the taxable portion.³ The penalty applies on top of ordinary income tax.

Several exceptions eliminate the additional tax. For nonqualified annuities under Section 72(q), it does not apply to distributions made after the owner’s death, on account of total and permanent disability, or as part of a series of substantially equal periodic payments over the owner’s life expectancy. For qualified annuities in an IRA, the list of exceptions is broader and includes unreimbursed medical expenses exceeding 7.5% of adjusted gross income, qualified higher education expenses, and up to $10,000 for a first-time home purchase.⁴

The Exclusion Ratio on Annuitized Payments

Once you annuitize a nonqualified contract and begin receiving periodic payments, the IRS uses an exclusion ratio to split each payment into a taxable portion and a tax-free return of your original investment. The ratio equals your total investment in the contract divided by the expected return over your lifetime. If you invested $108,000 and your expected return based on actuarial tables is $240,000, the ratio is 45%. That means 45% of each annual payment comes back tax-free, and you pay income tax on the remaining 55%.⁵

The exclusion ratio applies only until you’ve recovered your entire investment. After that, every payment is fully taxable at ordinary income rates.³ For qualified annuities, the exclusion ratio is zero or very small because little or none of the premium was paid with after-tax dollars.

Required Minimum Distributions

Variable annuities held inside an IRA or other qualified retirement account are subject to required minimum distribution rules. Under the SECURE 2.0 Act, owners must begin taking annual withdrawals by April 1 of the year after they turn 73. For people born in 1960 or later, that age rises to 75 starting in 2033. Missing an RMD triggers a steep penalty on the amount you should have withdrawn.

Nonqualified variable annuities are not subject to RMD rules during the owner’s lifetime. That’s one reason some people buy them with after-tax money even though IRA-based annuities also offer tax deferral. The tradeoff is that nonqualified annuities don’t produce a tax deduction on contributions.

Death Benefits

Every variable annuity includes a basic death benefit that protects your beneficiary if you die before annuitizing. The standard guarantee pays at least the total premiums you contributed minus any withdrawals you’ve taken.⁶ If the market has dropped and the account is worth less than what you put in, the insurer covers the difference. If the account has grown, the beneficiary typically receives the higher market value.

Many contracts offer enhanced death benefit riders for an additional fee, such as a stepped-up benefit that locks in the highest account value reached on specific anniversary dates. These sound appealing but add cost every year, so you’re paying an ongoing premium for a benefit your heirs may or may not need.

Death benefits are not tax-free to the beneficiary. If paid as a lump sum, the beneficiary owes ordinary income tax on the amount exceeding the owner’s unrecovered investment in the contract. Original after-tax premiums come back tax-free, but all growth is taxable.⁷ If the beneficiary elects to receive the death benefit as an annuity stream instead, the exclusion ratio applies to each payment and spreads the tax over time.

Swapping Contracts Without a Tax Bill

If you’re unhappy with your current variable annuity but don’t want to trigger a taxable event, Section 1035 of the Internal Revenue Code lets you exchange one annuity for another without recognizing any gain or loss.⁸ The new contract must name the same owner, and the exchange must be a direct transfer between insurance companies. If you take possession of the funds yourself, even briefly, the IRS will treat it as a taxable withdrawal.

Partial exchanges are also permitted. You can transfer a portion of one annuity’s cash value into a new contract tax-free, provided you don’t take any withdrawals from either the old or new contract within 180 days of the transfer.⁹ Break that window and the IRS can reclassify the transfer as a taxable distribution.

A 1035 exchange avoids income tax, but it doesn’t avoid surrender charges. If you’re still within the surrender period on your existing contract, the insurer will deduct the applicable penalty before transferring the funds. Check your surrender schedule before initiating the exchange.

Suitability and Your Rights as a Buyer

Variable annuities sit at the intersection of insurance and securities regulation. The SEC regulates the securities component, FINRA supervises the broker-dealers who sell them, and state insurance commissioners regulate the insurance features and the financial soundness of the issuing company.¹

When a financial professional recommends a variable annuity, the recommendation must satisfy both FINRA Rule 2330 and SEC Regulation Best Interest. Rule 2330 requires a suitability analysis covering your age, income, investment objectives, risk tolerance, and existing holdings before any sale is finalized. Reg BI adds a “best interest” standard that requires the professional to consider reasonably available alternatives and disclose material conflicts of interest.¹⁰ If a variable annuity was sold to you without proper consideration of your financial situation, you can file a complaint with FINRA or your state insurance commissioner.

1
U.S. Securities and Exchange Commission. Variable Annuities: What You Should Know
2
Investor.gov. Surrender Charge
3
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
4
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
5
Internal Revenue Service. Publication 939 – General Rule for Pensions and Annuities
6
Interstate Insurance Product Regulation Commission. Amendments to Additional Standards for Guaranteed Minimum Death Benefits for Individual Deferred Variable Annuities
7
Internal Revenue Service. Pension and Annuity Income
8
Office of the Law Revision Counsel. 26 U.S. Code 1035 – Certain Exchanges of Insurance Policies
9
Internal Revenue Service. Revenue Procedure 2011-38 – Section 1035
10
FINRA. Annuities Securities Products – 2026 Annual Regulatory Oversight Report