Annuities
What an annuity does
An annuity liquidates an estate - it protects against living too long, the mirror image of life insurance. The owner purchases the contract, the annuitant's life measures the payout, and the beneficiary receives any remaining value.
Structures
Immediate annuities begin payout within one period; deferred annuities have an accumulation phase and a payout phase. Fixed annuities guarantee a minimum interest rate, and the insurer bears investment risk. Variable annuities invest in a separate account; the owner bears risk, values are measured in accumulation units that convert to annuity units at annuitization, and sale requires a securities license and prospectus. Indexed annuities credit interest based on an index with a cap, floor, and participation rate. Payout options: life only, life with period certain, installment refund, and joint and survivor.
Taxation
Growth is tax-deferred. In a nonqualified annuity, withdrawals before annuitization are taxed LIFO; once annuitized, the exclusion ratio makes part of each payment a tax-free return of basis. Qualified annuities (IRAs) are fully taxable because contributions were pre-tax. A 10% penalty generally applies before age 59½, with exceptions such as death or disability. Section 1035 exchanges move annuity or life values tax-free.
Traps
Variable annuities guarantee principal (false - separate account risk), the exclusion ratio applies to IRAs (false), and surrender charges or market value adjustments are frequently tested. Also remember suitability/best-interest review and the free-look period.
Rule of thumb
Exclusion ratio = investment in the contract ÷ expected return; multiply by each payment to find the tax-free portion.
Worked example
$60,000 basis ÷ $120,000 expected return = 50%; a $1,000 monthly payment is $500 tax-free and $500 taxable until basis is recovered.