Variable annuities generally provide investors with downside protection for a fee (the insurance guarantee), while also providing market exposure that may give the investor upside potential.

A variable annuity is characterized by offering market exposure, and the risk and upside potential that comes with it, in the form of “separate accounts” which are institutional-level mirrors of retail mutual funds. Typically a variable annuity will not deplete the amount of your initial investment with sales charges, and may even credit your annuity with an initial bonus amount of several percent.

The charges and fees are built into it, however, and they make sure they can pay commissions to the agent who sold it to you by putting a surrender charge on the annuity to discourage your from closing the account for several years. With most annuities, you have a 10% withdrawal window that is free from surrender charges.

You can reallocate and rebalance your investments in your variable annuity over the years in an attempt to manage an investment strategy. If the account value tanks, you can lose your invested amount. There is such thing as principal protection riders to the annuity contract, however.

The riders are part of what make annuities a useful vehicle, but they all usually come with their own separate charge. A variable annuity might have a death benefit reset rider that will allow you to increase the amount that would go to your beneficiaries if the account value tanked.

They will all come with some form of income option, with which you can turn your variable annuity into a fixed income annuity. Some riders may let you turn portions of your accumulation value, as it’s called, into income.

Variable annuities grow tax-deferred, but, the tax treatment may not be so nice on withdrawals. On non-qualified money, variable annuities and have a last-in first-out policy, meaning the gains, which are the last things to go into the account, must the the first to come out of it, and therefore the entire withdrawal will be taxable, and not as capital gains, but as income.

This may still be the most advantageous place to grow money for some people, given the tax-deferral, if they have maxed-out their IRAs and other tax-advantaged vehicles.

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