Annuities and Retirement Products: Accumulation, Payout and Tax
How an annuity works
An annuity liquidates a sum of money over time or for life; it guards against living too long, the mirror image of life insurance. The owner holds all rights, the annuitant is the person whose life measures the payout, and the beneficiary receives any remaining value. During the accumulation phase the contract builds value; at annuitization it converts into an income stream. Immediate annuities begin payments within one payment interval; deferred annuities accumulate first.
Fixed annuities guarantee a rate. Equity-indexed annuities credit interest linked to an index, subject to a floor and a cap. Variable annuities invest in separate-account subaccounts, put investment risk on the owner, and require a securities license to sell. During accumulation the owner holds accumulation units; at annuitization the value converts to annuity units, whose number is fixed while their value fluctuates.
Typical charges include mortality and expense risk fees, administrative fees, and surrender charges with a free-withdrawal percentage.
Payout options
Life only (straight life) pays the most but leaves nothing to survivors; life with period certain, life with refund (installment or cash), joint and survivor (pays until the second death), fixed period, and fixed amount. Any guarantee added to a life payout reduces the payment amount.
Retirement plans and tax
Nonqualified annuities grow tax-deferred; before annuitization, withdrawals come out gain-first (LIFO) and carry a 10% penalty before 59½, with certain exceptions. Once annuitized, the exclusion ratio makes the portion representing after-tax basis tax-free. Section 1035 allows a tax-free exchange of life insurance into an annuity, or annuity into annuity - never annuity into life insurance. Qualified plans (IRA, Roth IRA, 401(k), 403(b), SEP, SIMPLE) follow contribution limits and required minimum distributions, generally starting at age 73 under SECURE 2.0.
Trap: In a variable annuity the insurer does not guarantee the account value, and an annuity-to-life-insurance 1035 exchange is not permitted.
Rule of thumb: The annuitant measures the income; the owner controls the contract.