Annuities and Retirement Products
How annuities work
An annuity liquidates a sum of money over time. Two phases: accumulation and annuitization (payout). Contracts are immediate (payout begins at once) or deferred; fixed (insurer guarantees the rate), variable (separate account, securities license required, owner bears investment risk), or indexed (credited by an index subject to a cap, floor, and participation rate).
Payout options
Life only, life with period certain, installment refund, and joint and survivor. Straight life pays the most because it promises nothing to survivors.
Taxation
Nonqualified annuities grow tax-deferred; withdrawals are LIFO (gains first) until annuitization, when the exclusion ratio applies: investment in the contract divided by expected return equals the tax-free percentage. Qualified plans (IRA, 403(b), 401(k), SEP) generally allow deductible contributions, tax all withdrawals as ordinary income, impose a 10% penalty before age 59½ with limited exceptions, and require distributions beginning at age 73.
Worked example
Cost basis $60,000; expected return $120,000; exclusion ratio = 50%. A $1,000 monthly payment is $500 tax-free and $500 taxable until basis is fully recovered, after which the entire payment is taxable.
Traps
- Surrender charges penalize early exit; most contracts allow about 10% free withdrawal annually.
- A 1035 exchange is tax-free only between like contracts (life to life, annuity to annuity).
- Suitability and best-interest review is required - document need, liquidity, and time horizon.
Rule of thumb: never fund a short-term goal with an annuity; surrender charges, penalties, and ordinary-income taxation all punish early access.