Key Takeaways
- Annuities are contracts with insurance companies that provide income, often for retirement.
- Accumulation phase: Money grows tax-deferred; contributions are NOT deductible.
- Annuitization: Converting the account into a stream of income payments.
- Fixed annuities guarantee a minimum interest rate - NOT a security.
- Variable annuities invest in separate accounts with market risk - ARE securities.
- LIFO taxation: Withdrawals come from EARNINGS first (taxable as ordinary income).
- 10% penalty on earnings withdrawn before age 59½.
- Exclusion ratio applies during annuitization to determine taxable portion.
Annuities
Annuities are contracts with insurance companies designed to provide income, typically during retirement. They offer tax-deferred growth and various payout options.
Annuity Phases
The Three Phases
| Phase | Description | Key Feature |
|---|---|---|
| Accumulation | Premium payments, money grows | Tax-deferred growth |
| Annuitization | Convert to income stream | Irrevocable decision |
| Payout | Receive periodic payments | Income for life or period |
Accumulation Phase Details
During accumulation:
- Premiums paid (single or periodic)
- Earnings grow tax-deferred
- No taxes until withdrawal
- Measured in accumulation units
Annuitization Phase Details
When annuitized:
- Account converts to income stream
- Decision is generally irrevocable
- Measured in annuity units
- Payments begin based on chosen option
Exam Tip: Accumulation units are used during the pay-in phase. Annuity units are used during the payout phase. Know the difference.
Types of Annuities
Fixed Annuities
| Feature | Description |
|---|---|
| Investment | General account of insurer |
| Returns | Guaranteed minimum interest rate |
| Risk | Insurance company bears investment risk |
| Payments | Fixed, predetermined amount |
| Regulatory Status | NOT a security (insurance only) |
| Suitable For | Conservative investors seeking guarantees |
Variable Annuities
| Feature | Description |
|---|---|
| Investment | Separate account (subaccounts) |
| Returns | Based on market performance |
| Risk | Contract owner bears investment risk |
| Payments | Variable, based on performance |
| Regulatory Status | IS a security (requires Series 6 or 7) |
| Suitable For | Investors seeking growth potential |
Fixed vs. Variable Comparison
| Factor | Fixed Annuity | Variable Annuity |
|---|---|---|
| Investment Risk | Insurance company | Contract owner |
| Account Type | General | Separate |
| Returns | Guaranteed minimum | Market-based |
| Securities License | No | Yes |
| Prospectus | No | Yes |
Indexed (Equity-Indexed) Annuities
| Feature | Description |
|---|---|
| Returns | Linked to market index (S&P 500) |
| Principal | Generally protected |
| Caps | Maximum return limited |
| Participation Rate | % of index gain credited |
| Regulatory Status | Generally insurance (not securities) |
Payout Options
Settlement Options
| Option | Payments | Death Benefit |
|---|---|---|
| Life Only (Straight Life) | For life only | None - payments stop at death |
| Life with Period Certain | Life or minimum period | Beneficiary receives remaining period |
| Joint and Survivor | Two lives | Surviving spouse continues |
| Period Certain | Fixed number of years | Beneficiary receives remaining |
| Lump Sum | One payment | None |
Life Only Details
- Highest periodic payment
- No beneficiary receives anything
- Payments end at annuitant's death
- Risk: Early death means lost money
Life with Period Certain
- Guarantees minimum number of payments
- Example: "Life with 10-year certain"
- If annuitant dies in year 5, beneficiary receives years 6-10
- If annuitant lives past year 10, payments continue for life
Joint and Survivor
- Covers two lives (typically spouses)
- Payments continue until both die
- Options: 100%, 75%, 50% survivor benefit
- Lower initial payments than single life
Exam Tip: Life Only provides the HIGHEST payment but NO survivor benefit. Joint and Survivor has LOWER payments but continues for the surviving spouse.
Annuity Taxation
Non-Qualified Annuity Tax Treatment
Contributions are made with after-tax dollars (no deduction).
Accumulation Phase Withdrawals (LIFO)
LIFO = Last In, First Out means earnings are withdrawn first:
| Withdrawal Order | Tax Treatment |
|---|---|
| First | Earnings (taxable as ordinary income) |
| After earnings exhausted | Principal (tax-free return of basis) |
Example:
- Cost basis: $100,000
- Current value: $150,000
- Earnings: $50,000
- First $50,000 withdrawn = 100% taxable
Early Withdrawal Penalty
| Situation | Penalty |
|---|---|
| Withdrawal before age 59½ | 10% penalty on taxable portion |
| Exceptions | Death, disability, annuitization |
Annuitization Phase (Exclusion Ratio)
During annuitization, the exclusion ratio determines the tax-free portion:
Exclusion Ratio = Investment in Contract ÷ Expected Return
| Component | Tax Treatment |
|---|---|
| Principal portion | Tax-free (return of basis) |
| Earnings portion | Taxable as ordinary income |
Example:
- Investment: $100,000
- Expected return (life expectancy): $200,000
- Exclusion ratio: 50%
- Each $1,000 payment: $500 tax-free, $500 taxable
Qualified vs. Non-Qualified
| Type | Contributions | Taxation |
|---|---|---|
| Qualified | Pre-tax (IRA, 401k) | 100% taxable on withdrawal |
| Non-Qualified | After-tax | Only earnings taxable (LIFO) |
Variable Annuity Fees
| Fee Type | Description | Typical Range |
|---|---|---|
| M&E (Mortality & Expense) | Insurance charges | 1.00% - 1.50% |
| Administrative Fees | Operating costs | 0.10% - 0.30% |
| Subaccount Expenses | Underlying fund expenses | 0.25% - 2.00% |
| Surrender Charges | Early withdrawal penalty | 7% declining to 0% |
| Rider Fees | Optional benefit costs | 0.25% - 1.00%+ |
Surrender Charges
Typical surrender charge schedule:
| Year | Surrender Charge |
|---|---|
| 1 | 7% |
| 2 | 6% |
| 3 | 5% |
| 4 | 4% |
| 5 | 3% |
| 6 | 2% |
| 7 | 1% |
| 8+ | 0% |
1035 Exchange
Section 1035 allows tax-free exchange of one annuity for another:
| Allowed Exchanges |
|---|
| Annuity → Annuity |
| Life insurance → Annuity |
| Life insurance → Life insurance |
| NOT Allowed |
|---|
| Annuity → Life insurance |
Exam Tip: Annuity earnings are taxed as ORDINARY INCOME, not capital gains. Withdrawals before 59½ incur a 10% PENALTY on the taxable portion. LIFO means earnings come out FIRST.
What is the tax treatment of earnings withdrawn from a non-qualified annuity before age 59½?
Under LIFO taxation, which portion of an annuity is withdrawn first?
Which annuity payout option provides the HIGHEST periodic payment?
A variable annuity is considered a security because: