A variable annuity is a contract between an investor and an insurance company in which the contract value and eventual income payments vary based on the performance of investment subaccounts — similar to mutual funds — selected by the policyholder. Variable annuities combine features of an insurance product (death benefit guarantee, annuitization options) with investment features (equity/bond subaccount exposure).
Key features include the accumulation phase (contributions grow tax-deferred) and the distribution phase (annuitization or lump-sum withdrawal). During accumulation, gains are tax-deferred; upon distribution, earnings are taxed as ordinary income (not at the favorable capital gains rate). Withdrawals before age 59½ are subject to a 10% early withdrawal penalty plus ordinary income tax on the gain portion.
Separate account assets are segregated from the insurance company's general account, providing protection from the insurer's creditors. Common contract features include a death benefit (at minimum, return of premium), living benefits (GMIB, GMWB, GMAB), surrender charges (typically 7 years declining), and annual fees (mortality and expense [M&E] fee + administrative fee + fund expense ratios), making variable annuities among the most expensive investment products.
Variable annuities require dual registration: the insurance company must be licensed in each state, and because variable annuities are securities, the selling representative must hold a securities license (Series 6 or 7) plus a state insurance license.
> Exam tip: On the Series 6 and Series 7, know that variable annuities are both insurance products and securities. Understand that gains come out first (LIFO tax treatment) — the taxable portion is withdrawn before return of premium. Know that the separate account is NOT a registered investment company for most purposes. Suitability is a major exam focus: variable annuities are long-term products unsuitable for short-term goals due to surrender charges and penalties.