Annuities and Retirement Products
Two phases and basic types
During accumulation, money grows tax-deferred; during annuitization (payout), the insurer makes periodic payments. Immediate annuities begin payouts within about a year; deferred annuities accumulate first. Fixed annuities guarantee a rate and pay from the insurer's general account. Variable annuities invest in a separate account, require a securities license and a prospectus, and shift investment risk to the owner. Indexed annuities credit interest linked to an index, subject to caps, participation rates, and a floor (often 0%).
Units and payout options
In variable annuities, accumulation units vary in number while the unit value fluctuates; at annuitization the contract converts to a fixed number of annuity units whose value fluctuates with the portfolio. Payout options include life only, life with period certain, joint and survivor, fixed period, fixed amount, and lump sum.
Taxation
Annuity growth is tax-deferred. Nonqualified withdrawals before annuitization are taxed LIFO - gains first - and before age 59½ generally carry a 10% penalty. Once annuitized, the exclusion ratio (investment in the contract divided by expected return) determines the tax-free portion of each payment. Qualified annuities (IRA, 401(k)) are funded with pre-tax dollars, so the entire payout is taxable. Required minimum distributions begin at 73 (75 for those born in 1960 or later).
Traps to watch
Surrender charges and market value adjustments apply to early withdrawals; most contracts allow about 10% free withdrawal per year. A 1035 exchange defers tax on annuity-to-annuity and life-to-annuity transfers, but annuity-to-life is not permitted.
Rule of thumb
Exclusion ratio = investment in the contract ÷ expected return; multiply that percentage by each payment to find the tax-free amount.