Annuities
What an annuity is
An annuity is a contract that liquidates a sum of money over time, protecting against the risk of living too long (longevity risk), while life insurance protects against dying too soon. The two phases are accumulation (premiums build a fund) and annuitization (payout). Immediate annuities begin payout within a period (commonly one year or one payment interval); deferred annuities accumulate first.
Types
Fixed annuities guarantee a rate and the insurer bears investment risk. Variable annuities invest in a separate account subaccounts, shift risk to the owner, require a prospectus and securities licensing, and use accumulation units during the accumulation phase and annuity units during payout. Indexed annuities credit interest by formula tied to an index, using caps, floors, and participation rates. Classification by payout: life only (highest payment, ends at death), life with period certain, joint and survivor, and annuity certain. Deferred annuities often carry surrender charges, market value adjustments, and a free withdrawal allowance.
Suitability and taxation
Annuity suitability focuses on time horizon, liquidity needs, and surrender exposure - an elderly buyer placing short-term funds in a long-surrender-charge contract is a classic red flag. A 1035 exchange moves an annuity to another annuity or to life insurance tax-free. Growth is tax-deferred; when annuitized, the exclusion ratio determines the nontaxable return of basis. Withdrawals before 59½ generally incur a 10% penalty on taxable amounts. Death distributions to beneficiaries are taxable to the extent of gain.
Rule of thumb
Exclusion ratio = investment in the contract ÷ expected return. Example: $50,000 basis, $100,000 expected return = 50%. Each $1,000 payment gives $500 tax-free and $500 taxable.