Life Insurance Exam Annuities Guide 2026: Everything You Need to Know
Annuities are one of the most heavily tested and most frequently missed topics on the Life & Health insurance licensing exam. Along with variable products, annuities consistently rank as the #2 hardest topic area behind only policy provisions.
This guide covers every annuity concept you'll see on the exam: the three types, both phases, all payout options, tax rules, and licensing requirements — with clear examples and memory tricks.
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Why Annuities Are So Hard on the Exam
Candidates struggle with annuities because:
- Three types (fixed, variable, indexed) have different features, risks, and licensing requirements
- Different phases (accumulation vs. annuitization) have different tax rules
- Multiple payout options each have different beneficiary rules and payment amounts
- Licensing crossover — variable annuities bring securities concepts into an insurance exam
- Tax rules combine LIFO, exclusion ratios, and early withdrawal penalties
Let's break each of these down.
What Is an Annuity?
An annuity is a contract between an individual and a life insurance company in which the company agrees to make periodic payments to the individual (the annuitant), either immediately or at a future date, in exchange for premium payments.
Key distinction: Life insurance protects against dying too soon. Annuities protect against living too long (outliving your money).
| Feature | Life Insurance | Annuities |
|---|---|---|
| Protects against | Premature death | Outliving savings |
| Accumulation | Cash value grows | Account value grows |
| Payout | Death benefit to beneficiary | Income payments to annuitant |
| Risk | Mortality risk | Longevity risk |
The Two Phases of an Annuity
Every annuity has two distinct phases, and the exam will test whether you can identify which phase applies:
Phase 1: Accumulation (Pay-In Period)
- The annuitant deposits money into the annuity
- Funds grow tax-deferred (no taxes until withdrawal)
- Can be funded with a single premium or periodic premiums
- Owner maintains control and can make withdrawals (with possible penalties)
Phase 2: Annuitization (Payout Period)
- The accumulated value is converted into periodic income payments
- Once annuitized, the decision is irrevocable — you cannot reverse it
- Each payment consists of a taxable portion (earnings) and a non-taxable portion (return of basis)
- The exclusion ratio determines the tax-free portion of each payment
Exam Tip: If the question describes someone making deposits, they're in accumulation. If they're receiving payments, they're in annuitization.
The Three Types of Annuities
1. Fixed Annuities
| Feature | Details |
|---|---|
| Returns | Guaranteed minimum interest rate |
| Risk | Insurance company bears the investment risk |
| Separate Account? | No — funds in the general account |
| License Required | Insurance license only |
| Regulated By | State Insurance Department only |
| Best For | Conservative investors wanting guaranteed returns |
How it works: The insurance company guarantees a minimum interest rate (e.g., 3%) and may pay a higher current rate. Your principal is protected, and you'll receive predictable income in retirement.
2. Variable Annuities
| Feature | Details |
|---|---|
| Returns | Not guaranteed — depends on investment performance |
| Risk | Annuitant bears the investment risk |
| Separate Account? | Yes — funds in a separate account (subaccounts) |
| License Required | Insurance license + Securities license (Series 6 or 7 + SIE) |
| Regulated By | State Insurance Department + SEC + FINRA |
| Best For | Investors wanting market growth potential |
How it works: Premiums are invested in subaccounts (similar to mutual funds) within a separate account. Returns depend on investment performance and are not guaranteed. The separate account is key — it isolates the annuitant's funds from the insurance company's general obligations and protects them if the insurer becomes insolvent.
Separate Account vs. General Account:
- General account: Where fixed annuity premiums go. The insurer invests conservatively and guarantees returns. If the insurer goes bankrupt, general account assets may be at risk.
- Separate account: Where variable annuity premiums go. Funds are legally separated from the insurer's assets. This protects the annuitant's money from the insurer's creditors.
Accumulation Units vs. Annuity Units:
- During the accumulation phase, each payment buys accumulation units. The number of units increases with each deposit, and the value per unit fluctuates with investment performance.
- During the annuitization phase, accumulation units convert to a fixed number of annuity units. The number of annuity units never changes, but the value per unit fluctuates — so monthly payments vary.
Why dual licensing? Because subaccounts are securities, selling variable annuities requires both an insurance license and a securities license. Variable annuities must also be sold with a prospectus (a legal disclosure document). This is one of the most frequently tested concepts.
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3. Indexed (Fixed Indexed) Annuities
| Feature | Details |
|---|---|
| Returns | Linked to a market index (S&P 500, DJIA, NASDAQ) |
| Risk | Limited — has a floor (usually 0%) and a cap |
| Separate Account? | No — classified as a fixed product |
| License Required | Insurance license only |
| Regulated By | State Insurance Department only |
| Best For | Investors wanting some market upside with downside protection |
How it works: Returns are tied to a market index, but with built-in protections:
| Protection | Description | Example |
|---|---|---|
| Floor | Minimum credited rate (usually 0%) | Market drops 15% → you earn 0% (no loss) |
| Cap | Maximum credited rate | Market rises 15% → you earn the cap (e.g., 7%) |
| Participation Rate | Percentage of index return credited | 80% participation: index rises 10% → you earn 8% |
| Spread | Percentage deducted from index return | 2% spread: index rises 10% → you earn 8% |
Exam Tip: Indexed annuities are classified as FIXED products (not variable), so they only require an insurance license. This is a common trick question.
Comparison Chart: Fixed vs. Variable vs. Indexed
| Feature | Fixed | Variable | Indexed |
|---|---|---|---|
| Guaranteed returns | Yes | No | Minimum floor |
| Market exposure | None | Full | Partial (with caps) |
| Separate account | No | Yes | No |
| Insurance license | Yes | Yes | Yes |
| Securities license | No | Yes | No |
| SEC/FINRA regulated | No | Yes | No |
| Risk bearer | Insurer | Owner | Shared |
| Prospectus required | No | Yes | No |
Immediate vs. Deferred Annuities
This classification is based on when payments begin, not the type of annuity:
| Feature | Immediate Annuity | Deferred Annuity |
|---|---|---|
| Premium | Single lump sum only | Lump sum or periodic |
| Payments begin | Within 12 months | After 12 months (typically at retirement) |
| Accumulation phase | None (or very short) | Yes — often years or decades |
| Common use | Convert savings to income now | Save for future retirement income |
Exam Tip: Immediate annuities are ALWAYS purchased with a single premium (you can't make periodic payments if you need income immediately).
Annuity Payout Options
This is a high-frequency exam topic. Know the trade-off: more protection for beneficiaries = lower periodic payments.
From Highest to Lowest Payment Amount:
| Payout Option | Periodic Payment | Beneficiary? | Key Feature |
|---|---|---|---|
| Life Income (Straight Life) | Highest | No | Pays for life; insurer keeps remainder at death |
| Life with Period Certain | High | Yes (during certain period) | Pays for life; if death during certain period, beneficiary receives remaining payments |
| Refund Life | Medium | Yes | Pays for life; if death before premiums recovered, beneficiary gets refund |
| Joint and Survivor | Lower | Surviving annuitant | Pays until both annuitants die; reduced payment after first death |
| Fixed Period Certain | Varies | Yes | Pays for set period (e.g., 20 years) regardless of life/death |
| Fixed Amount Certain | Set by owner | Yes | Pays set amount until funds exhausted |
Memory Trick: "Life Only = Largest Payments, No Leftovers." Straight life pays the most because the insurance company takes the risk of you dying early and keeping the rest.
Surrender Charges and Liquidity
Most annuities have a surrender period (typically 5-10 years) during which early withdrawals incur a surrender charge — a fee for accessing your money early.
| Year | Typical Surrender Charge |
|---|---|
| Year 1 | 7% |
| Year 2 | 6% |
| Year 3 | 5% |
| Year 4 | 4% |
| Year 5 | 3% |
| Year 6 | 2% |
| Year 7 | 1% |
| Year 8+ | 0% (surrender period over) |
Exam Tip: Surrender charges are separate from the IRS 10% early withdrawal penalty. A client who withdraws before 59½ AND during the surrender period could face BOTH charges. Most annuities allow penalty-free withdrawal of up to 10% per year during the surrender period.
Annuity Tax Rules
During Accumulation (Tax-Deferred Growth)
- Earnings grow tax-deferred — no annual tax on gains
- Premiums are paid with after-tax dollars (non-qualified annuity) or pre-tax dollars (qualified annuity)
Withdrawals During Accumulation (LIFO)
Non-qualified annuities use LIFO (Last In, First Out):
- Earnings come out first → taxed as ordinary income
- Premiums come out last → tax-free (return of basis)
- Before age 59½ → 10% early withdrawal penalty on taxable portion
Example: $100,000 total value ($80,000 premiums + $20,000 earnings). Withdraw $15,000:
- All $15,000 is earnings → taxed as ordinary income
- If under 59½ → additional $1,500 penalty (10% of $15,000)
During Annuitization (Exclusion Ratio)
Each payment during annuitization is split between taxable and non-taxable portions using the exclusion ratio:
Exclusion Ratio = Investment in Contract / Expected Return
The exclusion ratio determines the tax-free portion of each annuity payment.
Death Before Annuitization
- Beneficiary receives the greater of premiums paid or account value
- Gains above premiums are taxed as ordinary income to the beneficiary
Qualified vs. Non-Qualified Annuities
| Feature | Qualified | Non-Qualified |
|---|---|---|
| Funded with | Pre-tax dollars | After-tax dollars |
| Tax treatment | Entire withdrawal taxed | Only earnings taxed (LIFO) |
| Contribution limits | Yes (IRA/401k limits apply) | No |
| RMDs | Yes (starting at age 73) | No |
| Examples | IRA, 401(k), 403(b) annuities | Individual annuity contracts |
1035 Exchange
A 1035 exchange allows tax-free transfer between certain insurance products:
- Life insurance → Life insurance ✅
- Life insurance → Annuity ✅
- Annuity → Annuity ✅
- Annuity → Life insurance ❌ (cannot go "backwards")
Exam Tip: Think of it as a one-way street: you can always move from life insurance to annuity, but never from annuity back to life insurance tax-free.
Annuity Suitability
The exam tests whether you understand when annuities are appropriate:
Suitable for:
- Long-term retirement planning
- Tax-deferred growth needs
- Income that cannot be outlived
- Risk-averse investors (fixed annuities)
- Investors wanting market exposure with protection (indexed)
NOT suitable for:
- Short-term savings (surrender charges)
- Clients who need immediate liquidity
- Young investors with very long time horizons (fees may outweigh benefits)
- Funding Roth IRAs (already tax-advantaged — no benefit to adding annuity tax deferral)
Top Exam Mistakes on Annuity Questions
- Thinking indexed annuities are variable products. Indexed annuities are FIXED products — insurance license only, no prospectus required.
- Forgetting LIFO for withdrawals. Earnings come out first and are taxable. Premiums come out last.
- Confusing accumulation with annuitization. Deposits = accumulation. Payments received = annuitization.
- Missing the 10% penalty for early withdrawal. Before age 59½, withdrawals face a 10% penalty on the taxable portion.
- Not knowing dual licensing for variable annuities. Variable annuities require insurance + securities licenses. This is tested repeatedly.
Start Practicing Annuity Questions Now
Annuities don't have to be the topic that costs you the exam. With focused practice, you can turn this weakness into a strength:
Our AI tutor can explain any annuity concept in plain language — just click "Ask AI" on any question you get wrong. From fixed vs. variable to exclusion ratios, get instant help.