Annuities and Retirement Products
How annuities work
An annuity is a contract that liquidates a sum into an income stream the owner cannot outlive. During accumulation, the contract grows in accumulation units; during annuitization, the insurer converts value into annuity units and pays according to the selected option. Immediate annuities begin income within one payment period; deferred annuities accumulate first. Annuitization is generally irrevocable once elected.
Types and taxation
Fixed annuities guarantee a rate; variable annuities invest in separate accounts and pass investment risk to the owner (registered as securities, prospectus required); indexed annuities credit a formula linked to an index with a floor and cap. Qualified annuities sit inside IRAs or employer plans and are funded with pre-tax dollars; nonqualified annuities are funded with after-tax dollars, so growth is tax-deferred and only the earnings are taxed on withdrawal. The exclusion ratio (investment ÷ expected return) sets the tax-free portion of each annuitized payment. LIFO taxation applies to withdrawals before annuitization.
Payout options
Life only pays the most; life with period certain, installment refund, and joint and survivor pay less because they carry guarantees. Surrender charges and market value adjustments penalize early exits; most contracts allow a free withdrawal percentage annually.
Retirement plans
IRAs, Roth IRAs (after-tax contributions, qualified withdrawals tax-free), 401(k), 403(b), SEP, and SIMPLE plans have indexed contribution limits, catch-up provisions, and required minimum distributions beginning in the 70s under current law. 1035 exchanges move life insurance, annuities, and certain other contracts tax-free when values transfer directly.
Worked example: Owner invests $60,000 in a nonqualified annuity with an expected return of $120,000. The exclusion ratio is 50%, so half of each monthly payment is a tax-free return of basis.