Annuities
The mechanics
An annuity is a contract that liquidates an estate - the mirror image of life insurance. It has two phases: accumulation (paying in, values grow tax deferred) and annuitization/distribution (converting into income). Immediate annuities begin income about one payment period after purchase; deferred annuities accumulate first. Premium structures: single premium (one deposit), flexible (varied payments), and periodic.
Types
Fixed annuities guarantee a minimum rate (the insurer bears investment risk). Variable annuities put money in a separate account of subaccounts; the owner bears market risk, so the product is a security requiring a prospectus and securities registration. Variable contracts measure accumulation in accumulation units and income in annuity units. Indexed annuities credit interest linked to an index subject to caps, participation rates, and a floor. Equity-indexed and market value adjusted versions impose surrender charges or adjustments.
Qualified annuities (IRA, 403(b), pension) are funded with pre-tax dollars and distributions are fully taxable; nonqualified annuities are funded with after-tax dollars and enjoy the exclusion ratio, which makes part of each payment tax free.
Payout and taxation
Payout options: life only (highest payment, ends at death), life with period certain, joint and survivor, fixed period, fixed amount, and installment/unit refund. Surrender charges commonly decline over 7–10 years; many contracts allow a free withdrawal (often 10%) each year. A 1035 exchange moves annuity or life values between like contracts tax free. Becoming a MEC triggers LIFO taxation and a 10% pre-59½ penalty.
Worked example (exclusion ratio): An investor pays $60,000 for a nonqualified annuity with an expected return of $120,000. Exclusion ratio = 60,000 ÷ 120,000 = 50%. A $1,000 monthly payment is $500 tax free and $500 taxable until basis is fully recovered.
Trap: annuity death benefits are taxable to beneficiaries as income to the extent of gain - they are not income tax free like life insurance proceeds.