Annuities
How annuities work
An annuity liquidates a sum of money over time, protecting against longevity risk. Parties: owner (controls contract), annuitant (whose life measures payments), beneficiary. Two phases: accumulation (pay-in, tax-deferred growth) and annuitization/payout.
Immediate annuities begin payments within one payment period; deferred annuities accumulate first. Fixed annuities guarantee a rate; the insurer bears investment risk. Variable annuities invest in separate accounts, shifting risk to the owner and requiring a securities license plus prospectus. Indexed annuities credit interest based on an index subject to caps, participation rates, and floors. Market value adjustment and surrender charges apply to early withdrawal during the surrender period.
Payout options
Life only (highest payment, ends at death), life with period certain, installment/amount certain, joint and survivor (reduced when one annuitant dies), and refund (installment or cash) life. The more guarantees, the lower the payment.
Taxation basics
Contributions to a nonqualified annuity are made with after-tax dollars, so each payment is split using the exclusion ratio: the portion representing return of basis is tax-free; the rest is ordinary income. Withdrawals before annuitization are taxed LIFO (gain first). Withdrawals before age 59½ generally incur a 10% federal penalty (exceptions apply). 1035 exchanges move annuity money tax-free between contracts.
Suitability and best-interest standards require documenting the consumer's needs, surrender exposure, and liquidity.
Worked example: an owner withdraws $10,000 from a deferred annuity with $6,000 of gain. $6,000 is taxable ordinary income, $4,000 is basis, plus a 10% penalty on the gain if under 59½.