Annuities
Annuity mechanics
An annuity is a contract with an insurer that pays income, usually for life. During accumulation, premiums grow tax-deferred; at annuitization, the insurer converts the account into periodic payments. Immediate annuities begin payments soon after purchase; deferred annuities have an accumulation phase. Fixed annuities guarantee a rate and payout; indexed annuities credit interest by an index formula with caps, participation rates, and floors; variable annuities invest in separate accounts and fluctuate with market performance. Variable annuities are securities and require a prospectus and proper securities registration. Payout options include life only, life with period certain, joint and survivor, fixed period, and fixed amount. Life only usually pays the most because there is no refund guarantee.
Tax and traps
Deferred annuity growth is tax-deferred, not tax-free. Nonqualified annuity payments are partly taxable under the exclusion ratio; qualified annuity payments are generally fully taxable. Surrender charges and market value adjustments can reduce early withdrawals. A common trap is treating a variable annuity as a guaranteed insurance product; the owner bears investment risk.
Worked rule
A 65-year-old who wants income to begin now and last for life should compare an immediate life annuity. If she wants payments to continue to a survivor, use a joint and survivor option, accepting a lower payment than life only.