Annuities
Structure
An annuity is a contract that liquidates a principal sum over time, protecting against the risk of outliving income (longevity risk). It has two periods: accumulation (premiums paid, values build) and annuitization (payments to the annuitant). Immediate annuities begin payments within one payment interval; deferred annuities accumulate first. Fixed annuities credit a guaranteed rate; variable annuities invest in a separate account, so the contract owner bears investment risk, and the product is a security regulated by the SEC and FINRA in addition to state insurance regulation. Indexed annuities credit interest based on an external index with caps, participation rates, and floors.
Payout options
Straight life (life only) pays the highest income but nothing to survivors. Life with period certain, life with refund (installment or cash), and joint and survivor reduce the payment in exchange for guarantees. Fixed period and fixed amount options pay a defined sum rather than a lifetime income.
Taxation
For a nonqualified annuity, each payment is part return of basis and part taxable gain. Compute the exclusion ratio: investment in the contract ÷ expected return. Example: a $60,000 basis with an expected return of $150,000 gives 40% tax-free and 60% taxable per payment. Qualified annuities (IRA, 403(b)) receive no exclusion ratio - all payments are ordinary income, and early withdrawal before 59½ generally triggers a 10% penalty. Death benefits pass to beneficiaries; gains are taxable to them.
Traps
Surrender charges and market value adjustments apply to early withdrawals (commonly a 10% free withdrawal). Annuities are not life insurance - no pure death protection - and 1035 exchanges move values tax-free between like contracts.
Rule of thumb
Longevity risk → annuity; mortality risk → life insurance.