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How Do Variable Annuities Work?

Variable annuities are long-term investment vehicles designed to provide a combination of growth potential and income in retirement. They consist of two main phases: the accumulation phase and the payout phase.

Accumulation Phase

During the accumulation phase, you make purchase payments, which you can allocate to a variety of investment options. For example, you could designate 30% of your investment to a bond fund, 50% to a U.S. stock fund, and 20% to an international stock fund. The money you allocate to each investment option will increase or decrease over time, depending on the performance of the chosen funds. Therefore, it’s important to choose your investments wisely.

Investment Options

One of the advantages of variable annuities is the ability to transfer money between different investment options without incurring taxes on investment income and gains. This flexibility allows you to adjust your investment strategy in response to market conditions and your financial goals.

Tax Implications

While you can transfer money between investment options tax-free during the accumulation phase, withdrawing money from your account can have tax consequences. If you withdraw funds before the age of 59½, you may have to pay a 10% federal tax penalty in addition to regular income taxes on the withdrawal amount. Additionally, withdrawals in the early years of the accumulation phase may be subject to “surrender charges,” typically if the withdrawal exceeds 10% of the annuity’s value annually.

Payout Phase

At the beginning of the payout phase, you have the option to receive your purchase payments plus any investment income and gains as a lump-sum payment or as a stream of regular payments (typically monthly). If you choose the latter, you can select how long the payments will last. Common options include receiving payments for a fixed period (such as 10 or 20 years) or for the lifetime of you and your spouse or another beneficiary.

Withdrawal Penalties

It’s crucial to understand the conditions and potential penalties associated with early withdrawals. Planning your withdrawals carefully can help you avoid unnecessary fees and maximize the benefits of your variable annuity.

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