Annuities: Accumulation, Annuitization, and Taxation
The two phases
An annuity has an accumulation phase (premiums grow tax-deferred) and an annuitization phase (the contract pays a stream of income). Parties are the owner (controls the contract), the annuitant (whose life measures payout), and the beneficiary (receives any remaining value).
Classification
By timing: immediate (payout begins almost at once) vs. deferred. By premium: single vs. flexible. By funding: fixed (insurer guarantees a rate), indexed (credited by an index with caps, participation rates, and floors), and variable (separate account subaccounts; owner bears investment risk; securities license required).
Payout options
Straight life (highest income, nothing to survivors), life with period certain, joint and survivor, and period certain only. The more guarantees, the lower the payment.
Charges and liquidity
Surrender charges usually decline over a surrender period; many contracts allow a free withdrawal each year. Fixed deferred contracts may apply a market value adjustment on early surrender. 1035 exchanges move life-to-annuity or annuity-to-annuity without current tax.
Taxation
Nonqualified annuities: withdrawals before annuitization are taxed LIFO (gain first) and gains taken before 59½ may face a 10% penalty; once annuitized, the exclusion ratio recovers cost basis tax-free and taxes the rest. Qualified annuities (IRAs) are fully taxable.
Traps
- Confusing accumulation value with surrender value.
- Assuming a beneficiary always receives money under straight life - they do not.
- California gives buyers age 65+ a 30-day free look and requires suitability review for annuity sales to seniors.
Rule of thumb: variable = owner at risk with a securities license; fixed/indexed = insurer bears the investment risk.