Annuities
The two phases
Every annuity has an accumulation phase (premiums grow tax-deferred) and an annuitization/payout phase. Immediate annuities begin income within a year; deferred annuities accumulate and may be annuitized later or surrendered. Fixed annuities credit a guaranteed rate; indexed annuities credit an index-linked formula with caps and floors; variable annuities invest in separate subaccounts, are registered securities sold with a prospectus, and shift investment risk to the owner.
Parties
The owner controls the contract and names the annuitant (whose life measures payout) and the beneficiary. If the owner dies during accumulation, the value passes to the beneficiary. The annuitant is not necessarily the owner - a frequent question trap.
Payout options
Life only pays the highest income and stops at death; life with period certain guarantees payments for a minimum period; joint and survivor continues to the survivor; installment refund and cash refund return unpaid principal. Selection is generally irrevocable once annuitization begins.
Taxes
Exclusion ratio = investment in the contract ÷ expected return. That fraction of each payment is tax-free return of basis; the rest is ordinary income. Before annuitization, gains come out first (LIFO) on withdrawals, and a 10% penalty applies before age 59½ absent an exception. Annuities that fail the 7-pay test are MECs.
Suitability and exchange
Recommendations must be in the consumer's best interest: weigh surrender charges, bonus recapture, loss of living or death benefits, and the new surrender period created by a 1035 exchange. Replacement is not automatically wrong, but it must be justified.
Worked example
Basis $50,000; expected return $100,000; exclusion ratio 50%. A $1,000 monthly payment is $500 tax-free and $500 taxable until basis is recovered. Rule of thumb: free withdrawals are commonly 10% per year; excess withdrawals trigger surrender charges.