Annuities
What an annuity is
A contract that liquidates a lump sum into income and protects against outliving assets. Three parties: owner (controls contract, has rights), annuitant (life used to measure payout), beneficiary (receives remaining value at death). Two phases: accumulation (pay-in, cash value builds) and annuitization (payout, generally irrevocable).
Types
- Immediate vs deferred (payout begins immediately vs after a waiting period).
- Fixed (guaranteed rate/credited interest), variable (separate-account subaccounts - a security requiring a securities registration and prospectus), indexed (credited by index formula with cap, participation rate, and floor).
- Flexible vs single premium.
Payout options
Life only (maximum income, ends at death), life with period certain, period certain only, joint and survivor, and unit refund options. Longer guarantees mean smaller payments.
Taxation and features
During accumulation, growth is tax-deferred. At annuitization, the exclusion ratio makes part of each payment a tax-free return of basis; once basis is recovered, payments are fully taxable. Pre-59½ withdrawals may incur a 10% federal penalty plus ordinary income tax on gains (LIFO for deferred annuities). Surrender charges and market value adjustments may apply; most contracts allow some free withdrawal. 1035 exchanges move funds between annuity/life contracts tax-free.
Traps
- Variable annuity performance is not guaranteed - the separate account bears the market risk.
- If the annuitant dies before annuitization, the owner continues the contract; if the owner dies, the beneficiary receives the value.
- Annuitization is generally irreversible; settlement option choice matters.
Rule of thumb
Suitability first: long time horizon and tax deferral value justify cost. Short horizon = surrender charges and penalties.