Annuities and Retirement Products
Mechanics
An annuity liquidates a sum into income and shifts longevity risk to the insurer. There is an accumulation phase and then annuitization. Immediate annuities begin payments within one payment period; deferred annuities accumulate first. Fixed annuities credit a guaranteed rate; indexed annuities credit an index-linked return with a floor; variable annuities invest in separate-account subaccounts and require a FINRA registration and a prospectus.
Payout options
Straight life pays the most with no refund; life with period certain, installment refund, joint and survivor (usually reduced at the first death), fixed period, and fixed amount. Every added guarantee lowers each payment.
Taxation
Nonqualified annuity growth is tax deferred, and each payment contains a return of basis found with the exclusion ratio (investment in the contract divided by expected return). Distributions before age 59½ are ordinary income plus a 10% penalty unless an exception applies. Qualified plans (IRA, 401(k), 403(b), SEP, SIMPLE, Roth) follow their own rules; qualified Roth distributions are tax free. A Section 1035 exchange moves annuity to annuity, or life to annuity, tax free.
Traps
Surrender charges hit early withdrawals, though most contracts permit a free withdrawal each year (often 10%). Suitability means matching liquidity needs, time horizon, and risk tolerance, especially on a replacement. Keep the roles straight: an annuity guards against living too long; life insurance guards against dying too soon.
Worked example: a nonqualified annuity with $50,000 basis and a $100,000 expected return has an exclusion ratio of 50%, so half of each payment is tax free and half is taxable.
Rule of thumb: money already inside an IRA or 401(k) is tax deferred, so buying an annuity there wastes the deferral.