Annuities
What an annuity is
An annuity is a contract that liquidates a sum of money over time, protecting against longevity risk. Parties: owner (controls the contract), annuitant (whose life expectancy drives payments), beneficiary (receives survivor benefits). Two phases: accumulation (premiums grow tax-deferred) and annuitization (payout).
Types
Immediate annuities begin payments within a year of a single premium; deferred annuities accumulate first. Fixed annuities guarantee a rate; variable annuities invest in separate-account subaccounts (a security - requires a prospectus and registered representative) and shift investment risk to the owner; indexed annuities credit interest tied to an index with a cap and floor.
Payout options
Straight life (highest payment, nothing to survivors), life with period certain, installment refund, cash refund, joint and survivor, and period-certain-only plans.
Taxation and the exclusion ratio
Nonqualified annuity contributions are made with after-tax dollars, so part of each payment is a tax-free return of basis:
Exclusion ratio = investment in the contract ÷ expected return.
Worked example: basis $60,000; total expected payments $120,000. Exclusion ratio = 50%, so half of each payment is tax-free and half is ordinary income. Once basis is fully recovered, all payments are taxable. Withdrawals before annuitization are LIFO - earnings come out first and are taxed as ordinary income, and an early-withdrawal penalty generally applies before age 59½. Death benefits to beneficiaries are taxable to the extent of gain.
Traps
- Surrender charges and market value adjustments fall during early years; most contracts allow a free withdrawal (often 10%).
- 1035 exchanges move annuity or life cash values tax-free between like contracts.
- Annuities are not life insurance - there is no pure death protection, only a return of remaining value.