Annuities
What an annuity is
A contract that liquidates a sum of money over time, protecting against outliving income. The owner holds all rights; the annuitant is whose life measures the income; the beneficiary receives any unpaid balance. The accumulation phase builds value; annuitization converts it to income.
Varieties
Immediate annuities begin payments within a year (usually a month); deferred annuities accumulate first. Fixed annuities guarantee a rate; indexed annuities credit interest by formula with cap, participation rate, and floor; variable annuities invest in a separate account and are securities - registration and a prospectus are required. Premiums may be single or flexible.
Payout options
Life only pays the most and stops at death; life with period certain guarantees payments for a minimum period; installment refund and cash refund return unpaid principal; joint and survivor continues for the second annuitant, often at a reduced amount.
Taxes
Nonqualified annuity interest grows tax-deferred. Withdrawals before annuitization are taxed LIFO - earnings first - plus a 10% penalty before 59½. Once annuitized, the exclusion ratio makes part of each payment a tax-free return of basis: investment in the contract divided by expected return. A 1035 exchange moves an annuity or life policy to a new contract tax-free. Surrender charges and market value adjustments apply in early years.
Traps: applying the exclusion ratio to pre-annuitization withdrawals, assuming variable annuities need only a life license, and naming a beneficiary as owner - which can create a taxable gift.
Rule of thumb: the more guarantees a payout option offers, the smaller each check.