Variable Annuity Life Insurance

Everything You Need to Know about Variable Annuity Life Insurance

(And maybe even a little more)

Variable annuity life insurance

Financial products aren't easy, even in the age of the internet. Simply put, the difference between variable annuities and variable whole life insurance is a matter of life and death. Variable annuities protect your retirement income and life insurance protects your beneficiaries, except sometimes variable annuities also protect beneficiaries with life insurance.  


What Are Variable Annuities?

Variable annuities are designed for two things: building wealth and creating lifetime income for retirement. Variable annuities protect investors from outliving their income. Your annuity contract begins by making either a single payment or a series of payments. The most common variable annuity is a deferred variable annuity.

 Deferred variable annuities accumulate money for a period of time before the policy pays income. Deferred variable annuities accumulate money in investments selected by the owner called subaccounts. Like mutual funds or other investments, the value of the subaccounts is based on market performance. They’re not guaranteed. Unlike mutual funds, subaccount capital gains and dividends are tax-deferred.  

After the deferral period, variable annuities offer a menu of retirement income options:

Annuitization: Is an exchange of the account value for lifetime income. The income can be guaranteed for one life or for the longer of two lives (joint and survivor). There is no access to principal. 

Living Benefits: Offer a guaranteed minimum income from account withdrawals regardless of market conditions.  The owner still has access to the account value.

What Is Variable Life Insurance?


  • Proceeds are usually paid to a named beneficiary 
  • Proceeds are income tax-free to the beneficiary

Variable life insurance is designed to protect beneficiaries from economic loss. It's used to:

  • Protect families from loss of income 
  • Provide funds for specific purposes (i.e., education, special needs)
  • Provide funds for final expenses
  • Provide funds for legacy and charitable planning

Variable life insurance is a type of whole life. It's called whole life because it's designed to stay in force for the insured's entire life. Term insurance is designed only to stay in force for a set number of years. 

Over time, variable life insurance builds cash values that may be used for emergencies, income, or anything else. The cash values are tax-deferred.

Life insurance companies also offer a disability waiver of premium for an additional fee. If the insured is disabled, the insurance company will pay the premium and the policy will continue to build value. 

Variable life insurance policies offer subaccount investment choices just like variable annuities.

Variable Annuity Life Insurance

All variable annuities have a death benefit that protect  beneficiaries. The minimum death benefit is the account value. Some products offer higher minimum death benefits as well as enhanced death benefit riders. 

Most variable annuities offer enhanced death benefits as optional riders at an additional cost. Benefit bases are used to track the value of the enhanced death benefit. Benefit bases usually start out at the amount of the purchase payment. The death benefit increases from time to time by a formula or is equal to the account value, whichever is larger. The rider is often called a rollup death benefit. The cost of the rider is a percentage of the death benefit, commonly 0.65% or more.

Why pay for an enhanced death benefit? Even though the value of the underlying investments can be higher or lower than the purchase payment, the beneficiary will always receive a death benefit that has increased over time.

How Variable Annuity Life Insurance Is Taxed

Life insurance death benefits are income tax free. Not so with variable annuity life insurance death benefits. The proceeds are taxable as a distribution.

Variable annuities are tax-deferred investments. Uncle Sam doesn’t want to let the proceeds sit in a tax-deferred account forever. The rules are that annuity death benefits must be distributed at the death of the owner. If you are a surviving spouse, you can take ownership of the annuity including any riders and death benefits within one year of your spouse's death. There is no income tax due until distributions begin.

Other options for beneficiaries are:

Five-year deferral: Take up to five years from the owner's death to withdraw the inheritance. Taxes are not due until withdrawals are taken. The money will continue to accumulate tax deferred.

Lump-sum distribution: Taxes are due in the year taken.

Stretch distribution: The distribution is taken as a percentage over time. Taxes are due as you receive the payments. The distributions may be partially or fully taxable.

Annuitization: The assets are converted into income and the payments will be partially taxable according to an exclusion ratio.

Your beneficiary can decide what option to take based on their immediate needs and tax situation.

The death benefit of a variable annuity that is in a qualified retirement plan or IRA is taxed to the beneficiary as any other inherited retirement plan or IRA.

Variable Annuities vs. Life Insurance

The long and short of it is that annuities protect your retirement income. Life insurance protects your beneficiaries from economic loss. The chart below illustrates the differences.

Guaranteed retirement income     NoYes
Death benefitSpecified by ownerAccount or enhanced value
Tax-deferred accumulation    YesYes
Income tax-free death benefitYesNo
Tax treatment of income                                           OrdinaryOrdinary
Penalty for early withdrawalOnly if MECYes
Surrender chargesYesYes
Disability waiverYesNo
Long-term care benefitYesLimited
Creditor protectionYes by state     Yes by state     

Converting Life Insurance to a Variable Annuity

A tax-free transaction, known as a 1035 Exchange, is available to exchange life insurance for a variable annuity. What this means is when the life insurance is liquidated to buy an annuity, no tax is due. The annuity distribution rules will apply going forward. 

Life insurance is a valuable benefit, especially if the policy has been in force for many years. Review the insurance need and any surrender penalties before exchanging life insurance for an annuity.

A 1035 transaction has to follow IRS rules to qualify for the tax benefit. An independent insurance agent can help you decide if converting your life insurance to a variable annuity is right for you. Consult your professional advisor for tax or legal advice.

Converting Variable Annuities to Life Insurance

There is no tax-free exchange to convert an annuity to life insurance. There are some circumstances when annuities to life insurance may be a good planning strategy, but usually the transaction does not make financial sense. 

Variable Annuity or Variable Life?

Variable annuity death benefits are taxable and they are not a substitute for life insurance. However, variable annuity death benefits can be a good planning strategy for investors who are not in good health, or otherwise can't  get life insurance. 

If you have maxed out your 401k, IRA, or other retirement savings plan, you may be looking for additional options. Variable annuities accumulate tax deferred, and can provide retirement income guaranteed for life. 

Variable annuities and variable life insurance are flexible financial planning tools, but they're not for everyone. Independent insurance agents are annuity professionals. They can explain the options and help you decide what's right for you.
