Annuities and Retirement Planning
Annuity Mechanics
An annuity is a contract that pays a stream of income, typically for retirement. Know the accumulation phase (premiums grow) and annuitization phase (payments begin). Distinguish immediate vs. deferred annuities, fixed vs. variable annuities, and indexed annuities. Know the surrender charge schedule, free withdrawal provisions, and surrender period. Understand annuitization options: life only, life with period certain, joint and survivor, and period certain.
Know the tax treatment: annuity growth is generally tax-deferred; withdrawals are taxed as ordinary income to the extent of gain; early withdrawals before age 59½ may incur a 10% penalty plus income tax. Know qualified vs. nonqualified annuities and the role of 1035 exchanges.
Traps in Questions
- Fixed vs. variable. Fixed annuities guarantee a rate; variable annuities shift investment risk to the owner and require a securities license.
- Exclusion ratio. For nonqualified annuities, part of each payment may be a tax-free return of basis; the ratio determines the taxable portion.
- Surrender charges. Charges typically decline over the surrender period; free withdrawal amounts are usually limited.
- Life only vs. period certain. Life only pays the longest income but nothing to survivors; period certain guarantees payments for a minimum period.
Worked Example
An annuitant invests $100,000 and expects $150,000 in total payments over the payout period. The exclusion ratio is 100,000 ÷ 150,000 ≈ 66.7%, so about two-thirds of each payment is a tax-free return of basis and one-third is taxable until basis is recovered.
Rule of Thumb
Match the annuity to the goal: immediate for current income, deferred for accumulation; fixed for guarantees, variable for growth potential with market risk.