Annuities and Retirement Products
How annuities work
An annuity is a contract that liquidates a lump sum into income and grows tax-deferred. Parties: owner (controls the contract), annuitant (whose life measures payments), beneficiary. Two phases: accumulation and annuitization (payout). Immediate annuities begin income within a year; deferred annuities accumulate first.
Types
Fixed annuities guarantee a rate and a minimum payout. Variable annuities invest in a separate account, carry investment risk on the owner, and require a life insurance license plus securities registration and a prospectus. Indexed annuities credit interest based on an index, limited by a cap, protected by a floor, and adjusted by a participation rate. Market value adjustments and declining surrender charges penalize early withdrawal, usually with a free-withdrawal allowance.
Payout options and taxation
Options: straight life (highest payment, ends at death), life with period certain, installment or cash refund, and joint and survivor. The exclusion ratio (investment in the contract ÷ expected return) sets the tax-free portion of each payment; once basis is recovered the full payment is taxable. Withdrawals from a deferred annuity are taxed LIFO - gains first - as ordinary income, and before age 59½ a 10% federal penalty generally applies. Section 1035 exchanges move annuity or life values between contracts without current tax.
Retirement plans
Qualified plans (401(k), 403(b), IRA, SEP, SIMPLE, defined benefit and defined contribution) receive favorable tax treatment and are governed by ERISA where employer-sponsored. Traditional IRA contributions may be pre-tax with taxable withdrawals; Roth contributions are after-tax with tax-free qualified withdrawals. Required minimum distributions generally begin at age 73.
Worked example
$60,000 invested with an expected return of $120,000 gives an exclusion ratio of 50%, so half of every payment is tax-free until basis is recovered.