Annuities
How annuities work
An annuity is a contract that pays an income, usually for retirement. The accumulation phase builds value; the payout phase distributes it. Immediate annuities begin payments soon after purchase; deferred annuities accumulate first. Fixed annuities credit a guaranteed rate. Variable annuities invest in separate accounts and require a securities license; the owner bears investment risk. Indexed annuities credit interest linked to an index with caps, participation rates, and floors.
Payout choices
Life-only pays the highest income but stops at death. Life with period certain guarantees payments for a minimum period. Joint and survivor continues while either annuitant lives. Period-certain-only pays for a set time with no life contingency. Annuitization converts principal into income; it is generally irreversible. Surrender charges may apply to early withdrawals, and withdrawals before age 59½ may incur a tax penalty. Qualified annuities use pre-tax dollars; nonqualified annuities use after-tax dollars.
Taxation
Nonqualified annuity income is taxed under the exclusion ratio: investment in the contract divided by expected return. That portion of each payment is tax-free; the remainder is taxable. Once basis is recovered, payments are fully taxable. Death proceeds generally pass to a named beneficiary outside probate.
Traps
An annuity is not life insurance and does not create an insurable interest. Variable annuities are securities. Do not assume all annuity withdrawals are tax-free. Do not confuse the accumulation phase with the payout phase.
Rule of thumb
Fixed means insurer guarantees; variable means market risk; indexed means formula-linked with limits. For taxation, exclude basis first, then tax the rest.
Worked example
An annuitant invested $50,000 and expects $100,000 of total payments. The exclusion ratio is 50%. From a $1,000 monthly payment, $500 is tax-free return of basis and $500 is taxable until basis is recovered.