Annuities
Mechanics
An annuity liquidates a sum of money over time - the reverse of life insurance. During accumulation the contract builds value; during annuitization it pays out. The owner, annuitant, and beneficiary may be different people. Immediate annuities begin payments within one payment period; deferred annuities postpone payout.
Types
Fixed annuities guarantee a minimum interest rate and a fixed dollar payout, so the insurer bears investment risk. Variable annuities invest in a separate account; units are accumulation units before annuitization and annuity units after, and payments vary with subaccount performance relative to the assumed interest rate (AIR) - performance above the AIR raises payments. Variable sales require a securities license and a prospectus. Indexed annuities credit interest by an index subject to a cap, participation rate, and floor. Single versus flexible premium describes funding.
Payout options
Life only (highest payment), life with period certain, installment and cash refund, fixed period, fixed amount, and joint and survivor. Payment size depends on age (a younger annuitant receives less), assumed interest, and the option chosen.
Taxation
Growth is tax-deferred. Annuitized payments use the exclusion ratio: investment in the contract divided by expected return gives the tax-free portion of each payment; the remainder is ordinary income. Non-annuitized withdrawals are LIFO, gains first. A 10% penalty applies to taxable amounts before age 59 1/2 except at death, disability, or as part of a life annuity. A 1035 exchange moves an annuity or life policy without tax.
Trap: surrender charges and market value adjustments reduce early withdrawals, and the separate account value of a variable annuity is never guaranteed.