Annuities
How annuities work
An annuity is a contract that accumulates funds and then pays an income stream. During accumulation, the contract earns interest or investment returns. At annuitization, the accumulated value is converted into periodic payments. Immediate annuities begin payments soon after purchase; deferred annuities have an accumulation phase. Fixed annuities credit a guaranteed rate; variable annuities invest in subaccounts and carry market risk; indexed annuities credit interest based on an index subject to caps and participation rates.
The owner controls the contract, the annuitant is the measuring life, and the beneficiary receives any death benefit. Payout options include straight life, life with period certain, joint and survivor, fixed period, and fixed amount. Straight life pays the most because payments stop at death with no refund.
Taxes and traps
Nonqualified annuities have cost basis. The exclusion ratio equals investment in the contract divided by expected return, determining the tax-free portion of each payment. Qualified annuities generally have no basis and are fully taxable. Withdrawals before age 59½ may incur a 10% federal penalty. Surrender charges can apply early. Variable annuities are securities and require proper licensing.
Worked example
A nonqualified annuity has a $100,000 basis and an expected return of $200,000. The exclusion ratio is 50%, so half of each payment is a tax-free return of basis. Rule of thumb: exclusion ratio = investment in contract ÷ expected return.