Annuities
What an annuity is
An annuity is a contract that liquidates a sum of money over time, protecting against the risk of outliving income (longevity risk). The owner funds it; the annuitant's life measures the payout; the beneficiary receives any survivor benefit. During the accumulation phase the account grows tax-deferred. During annuitization the insurer converts accumulated value into periodic payments.
Types
Immediate annuities begin payments within one payout period; deferred annuities accumulate first. Fixed annuities guarantee a declared interest rate. Variable annuities invest in subaccounts and carry market risk; they are securities, so the producer needs both a life license and FINRA registration, and a prospectus must be delivered. Indexed annuities tie credits to an index with caps, participation rates, and floors.
Payout options
Life only pays the most but ends at death. Life with period certain guarantees payments for a minimum period. Installment refund and cash refund return the unpaid balance to the beneficiary. Joint and survivor continues for a second annuitant.
Taxes
Nonqualified annuities are funded with after-tax dollars, so each payment is part principal (tax-free) and part interest (taxable) under the exclusion ratio. Qualified annuities (IRA, 401(k)) are funded pre-tax, so the entire payment is taxable. Withdrawals before age 59½ generally incur a 10% penalty. A 1035 exchange moves funds between annuities, or from life insurance to an annuity, tax-free.
Traps
The exclusion ratio applies only to nonqualified contracts. Surrender charges apply to early withdrawals, not to annuitization. Variable annuities are not FDIC-insured.
Rule of thumb
Principal back tax-free means nonqualified; fully taxable payments mean qualified.