Variable Annuities Explained: Risks, Costs, and Exit Strategies in 2026

What exactly is a variable annuity and how does it function?

A variable annuity is a tax-deferred insurance contract where your account value fluctuates based on the performance of underlying sub-accounts.

Unlike fixed annuities that offer a guaranteed interest rate, variable annuities allow you to allocate funds to mutual fund-like sub-accounts. Your potential for gain is higher, but you bear the investment risk directly. These products are often sold for retirement income, but their internal cost structure frequently surprises investors years later.

How do the internal fees impact your overall account growth?

Most variable annuities carry annual fees ranging from 2% to 4%, covering mortality and expense charges, administrative costs, and rider premiums.

These fees are deducted from your account value regardless of market performance. Over a long period, these costs significantly erode the compound growth you might otherwise achieve in a standard brokerage account. Many investors do not realize these fees are taken annually until they view a complete annual statement.

Why does the surrender charge schedule reset so often?

Surrender charges typically range from 5% to 10% in year one and decline over a 7- to 10-year period, effectively locking you into the policy.

I have reviewed countless cases where advisors suggested a 1035 exchange to a “new and better” annuity, which unintentionally reset the surrender charge clock entirely. This practice, known as churning, is a common way for agents to generate new commissions while restarting your exit penalty period. Before signing any exchange paperwork, always ask for the full surrender schedule of the new contract versus the existing one.

What are the most common financial risks with variable annuities?

The primary risks involve high surrender penalties, potential market losses in sub-accounts, and significant tax impacts upon early withdrawal.

How do you calculate your net surrender value correctly?

Your net surrender value is the total account balance minus the applicable surrender charge, any outstanding policy loans, and administrative fees.

The single most common misconception I encounter is that the account value shown on a statement is the amount you will receive upon cancellation. It is not. That figure is the gross account value; your actual check will be lower after the insurer deducts the surrender penalty defined in your specific contract.

What happens to your money if you withdraw before age 59½?

Early withdrawals before age 59½ trigger a 10% IRS penalty in addition to ordinary income taxes on all gains distributed from the account.

• Ordinary income tax rates apply to all investment gains.
• The 10% penalty applies to the taxable portion of your distribution.
• State income taxes may also apply depending on your jurisdiction.
• Surrender charges are separate from these government-imposed penalties.

What are the alternatives to holding a variable annuity?

Alternatives include tax-efficient index funds, 1035 exchanges to lower-cost products, or using the 10% free withdrawal provision annually.

Can a 1035 exchange help you lower your total costs?

A 1035 exchange allows you to move funds from one annuity to another tax-free, potentially accessing lower fees if the new contract is superior.

However, you must be extremely cautious about surrender charge periods. Ensure that any reduction in annual expenses is not offset by a new, lengthy surrender penalty period that limits your future liquidity. You can learn more about the tax mechanics of these moves by reviewing our 1035 exchange guide.

Is the 10% annual free withdrawal a viable strategy?

Most contracts permit a 10% penalty-free withdrawal of the contract value per year, though these are still subject to income tax and potential IRS penalties.

The Insider Detail Most People Overlook

What many policyholders miss is the “confinement waiver” often buried in the fine print of variable annuity contracts. If you are diagnosed with a terminal illness or need long-term care in a nursing facility, most insurance carriers will waive the surrender charges entirely. I have assisted clients who were prepared to pay a massive surrender fee only to find they qualified for a full waiver based on a medical diagnosis. Always check your contract for these specific rider provisions before proceeding with an expensive surrender. The insurer will rarely volunteer this information, as they prefer to retain the assets or charge the penalty. Ensure you have your medical documentation ready to submit alongside the surrender request if you intend to trigger this clause.

Frequently Asked Questions