Annuities
Accumulation and payout
An annuity is a contract that accumulates money and then pays income, usually for retirement. During accumulation, the contract builds value; at annuitization, it converts to a payout stream. Immediate annuities begin payments soon after purchase; deferred annuities accumulate first. Fixed annuities guarantee a minimum rate and payout. Variable annuities invest in separate accounts, carry investment risk, and require a prospectus. Indexed annuities credit interest linked to an index with caps and floors. Surrender charges and market value adjustments may apply to early withdrawals.
Payout options include life only, life with period certain, joint and survivor, and period certain. Life only pays the highest income but stops at death. Life with period certain guarantees payments for a minimum period to a beneficiary if the annuitant dies early. Joint and survivor continues for a surviving spouse. The exclusion ratio determines how much of each annuity payment is a tax-free return of investment and how much is taxable income.
Traps
Do not confuse the owner, annuitant, and beneficiary. Variable annuities are securities and require a prospectus. Fixed annuities guarantee a minimum but not a high return. Annuity withdrawals before age 59½ may trigger a 10% federal penalty on taxable amounts, and surrender charges may also apply.
Worked example
An annuitant invested $60,000 and expects $90,000 of total payments. The exclusion ratio is $60,000 ÷ $90,000 = 66.7%. If a monthly payment is $1,000, about $667 is excluded from income and $333 is taxable until basis is recovered.