Annuities
What an annuity does
An annuity is often called the opposite of life insurance: it liquidates an estate rather than creating one, and it protects against the risk of living too long by pooling longevity risk. Contributions are made with after-tax dollars in nonqualified annuities and grow tax-deferred; there is no premium deduction.
Structure
Two phases: accumulation and annuitization (payout). Contracts are immediate (payout begins within about a year) or deferred. Fixed annuities guarantee a rate. Variable annuities invest in subaccounts, are securities, require a prospectus and FINRA registration, and shift investment risk to the owner. Indexed annuities credit interest from an external index, subject to a floor and cap.
Payout options
Life only (highest payment, nothing to survivors), life with period certain, installment refund, cash refund, and joint and survivor. The longer the guarantee, the smaller the payment.
Taxation
In a nonqualified annuity, the exclusion ratio determines how much of each payment is a tax-free return of basis; once basis is recovered, payments are fully taxable. Before annuitization, withdrawals are taxed last-in, first-out, so gains come out first. Withdrawals before age 59½ generally trigger a 10% IRS penalty.
Charges and mechanics
Surrender charges commonly run about seven years, with free withdrawal provisions. In a variable annuity, accumulation units stay fixed in number and change in value, while annuity units vary in number with performance during payout.
Traps
"Life only pays less" is wrong. "Annuity premiums are deductible" is wrong. Variable annuities are not FDIC insured.
Rule of thumb
The bigger the insurer's guarantee, the smaller the check. Life only maximizes income and minimizes guarantees.