Annuities Overview

Annuities are contracts between an individual and an insurance company designed to provide guaranteed income, typically for retirement. They address a fundamental retirement planning concern: the risk of outliving one's assets. This section covers the basic structure, phases, timing options, and taxation of annuities—concepts frequently tested on the CFP exam.

What Is an Annuity?

An annuity is a contract in which an individual pays premiums (either as a lump sum or periodic payments) to an insurance company in exchange for a future income stream. The insurance company pools these payments with those of other annuity holders and uses actuarial principles to guarantee payments for a specified period or for life.

Key Characteristics

• Contract with an insurance company: Unlike mutual funds or stocks, annuities are insurance products
• Guaranteed payments: The insurer assumes the risk of providing payments regardless of market conditions or longevity
• Tax-deferred growth: Earnings accumulate without current taxation
• Designed for retirement: Primary purpose is providing income during retirement years
• Protection against longevity risk: Payments can continue for life, regardless of how long the annuitant lives

When Annuities Make Sense

Annuities are appropriate when clients:

• Have maximized contributions to qualified retirement plans (401(k), IRA)
• Desire guaranteed lifetime income
• Are concerned about outliving their assets
• Want tax-deferred growth beyond qualified plan limits
• Do not need liquidity or immediate access to funds

Annuities are generally not appropriate when clients:

• Need access to funds before retirement
• Want to leave significant assets to heirs
• Seek maximum growth potential with market exposure
• Have not yet maximized tax-advantaged retirement accounts

The Two Phases of Deferred Annuities

Deferred annuities have two distinct phases. Understanding these phases is critical for the CFP exam.

Accumulation Phase

The accumulation phase is the period when premiums are paid and the annuity grows in value. During this phase:

• The owner makes premium payments (single premium or periodic)
• Earnings grow tax-deferred
• The account has a cash surrender value
• Withdrawals may trigger surrender charges and early withdrawal penalties
• No income payments are being received

The accumulation phase can last for years or even decades, depending on when the owner decides to begin receiving income.

Annuitization Phase (Payout Phase)

The annuitization phase begins when the owner converts the accumulated value into a stream of income payments. Key characteristics include:

• Periodic payments begin and continue for a specified period or lifetime
• The exclusion ratio determines the taxable portion of each payment
• Once annuitized, the decision is typically irrevocable
• Cash surrender value usually no longer exists
• Payments are guaranteed by the insurance company

Exam Tip: Accumulation Units vs. Annuity Units

For variable annuities specifically, the CFP exam may test the distinction between accumulation units and annuity units. During the accumulation phase, the owner holds accumulation units (similar to mutual fund shares). At annuitization, these convert to annuity units, which determine the payment amount. The number of annuity units remains fixed, but their value fluctuates with the underlying investments.

Immediate vs. Deferred Annuities

Annuities are classified by when income payments begin.

Immediate Annuities

An immediate annuity begins making payments within one year of purchase—typically within the first month. Characteristics include:

• Purchased with a single lump-sum premium
• No accumulation phase
• First payment usually within 30 days
• Useful for retirees who need income immediately
• Often used to convert retirement account balances to guaranteed income
• Also called single premium immediate annuities (SPIAs)

Example: A 65-year-old retiree uses $200,000 from a 401(k) rollover to purchase an immediate annuity. Payments of $1,100 per month begin the following month and continue for life.

Deferred Annuities

A deferred annuity delays income payments to a future date, allowing the account to grow during the accumulation phase. Characteristics include:

• Can be purchased with a single premium or periodic payments
• Accumulation phase allows tax-deferred growth
• Annuitization can be triggered at the owner's discretion
• Useful for individuals still in their working years
• More flexible than immediate annuities

Deferred Annuity Payment Options

• Single Premium Deferred Annuity (SPDA): Funded with one lump-sum payment
• Flexible Premium Deferred Annuity (FPDA): Allows multiple premium payments over time

Qualified Longevity Annuity Contracts (QLACs)

A Qualified Longevity Annuity Contract (QLAC) is a special type of deferred annuity purchased within a qualified retirement account (IRA, 401(k), 403(b)) that can delay RMDs until as late as age 85.

Key QLAC rules (2025):

• Maximum purchase: Up to 25% of retirement account balance OR $210,000 (whichever is less)
• RMD exclusion: QLAC value is excluded from RMD calculations until payments begin
• Latest start date: Payments must begin by age 85
• No cash surrender value: Cannot be surrendered for lump sum
• Death benefits: May include return of premium feature

Planning insight: QLACs are particularly valuable for clients who don't need all their retirement income early, want to reduce current RMDs, or are concerned about longevity risk beyond age 85.

Annuity Taxation

Understanding annuity taxation is essential for CFP candidates. The tax treatment varies based on whether the annuity is qualified or non-qualified.

Qualified vs. Non-Qualified Annuities

Qualified annuities are funded with pre-tax dollars within a retirement plan (IRA, 401(k)). The entire withdrawal amount is taxable as ordinary income because no taxes have been paid on contributions or earnings.

Non-qualified annuities are funded with after-tax dollars. Only the earnings portion is taxable; the original premium (basis) is returned tax-free.

Tax-Deferred Growth

Both qualified and non-qualified annuities benefit from tax-deferred growth. Earnings are not taxed until withdrawn, allowing the full amount to compound over time. This provides a significant advantage over taxable investments for long-term accumulation.

The Exclusion Ratio

For non-qualified annuities receiving periodic payments, the exclusion ratio determines what portion of each payment is tax-free (return of principal) versus taxable (earnings).

Exclusion Ratio Formula:

Exclusion Ratio = Investment in Contract / Expected Return

Where:

• Investment in Contract = Total premiums paid (basis)
• Expected Return = Annual Payment x Life Expectancy (from IRS tables)

Example: Sarah, age 65, annuitizes a non-qualified annuity with a $100,000 investment. Her annual payment is $8,000, and her life expectancy is 20 years.

• Expected Return = $8,000 x 20 = $160,000
• Exclusion Ratio = $100,000 / $160,000 = 62.5%

Each year, 62.5% of her $8,000 payment ($5,000) is tax-free return of principal, and 37.5% ($3,000) is taxable as ordinary income.

Important: If the annuitant outlives the life expectancy used in the calculation, all subsequent payments become fully taxable. The exclusion ratio applies only until the investment is fully recovered.

The 10% Early Withdrawal Penalty

Withdrawals from annuities before age 59 1/2 are subject to a 10% early withdrawal penalty on the taxable portion, in addition to ordinary income tax. This penalty is similar to early distributions from IRAs and 401(k)s.

Penalty calculation for non-qualified annuities:

• The 10% penalty applies only to the earnings portion (taxable amount)
• The return of basis is not subject to the penalty

Penalty calculation for qualified annuities:

• The entire withdrawal is subject to the 10% penalty (since no taxes were paid on contributions)

Exceptions to the 10% Penalty

The penalty may be waived in certain circumstances:

LIFO Rule for Withdrawals

For non-qualified annuities, withdrawals during the accumulation phase are taxed on a Last-In, First-Out (LIFO) basis. This means earnings are considered withdrawn first and are fully taxable before any return of principal.

Example: A non-qualified annuity has $100,000 in premiums paid and $30,000 in earnings (total value $130,000). If the owner withdraws $20,000, the entire amount is taxable as ordinary income because it comes from the earnings portion first.

Exam Tip: LIFO vs. Exclusion Ratio

Remember: LIFO applies to withdrawals during the accumulation phase. The exclusion ratio applies to annuity payments during the payout phase. This distinction is commonly tested on the CFP exam.

Annuity Payout Options

When an annuity is annuitized, the owner selects a payout option that determines how payments are calculated and how long they continue.

Life Only (Straight Life)

Payments continue for the annuitant's lifetime only. Payments cease at death, even if the annuitant dies shortly after annuitization.

• Advantage: Highest monthly payment
• Disadvantage: No payments to beneficiaries after death
• Best for: Healthy individuals with no need to leave assets to heirs

Life with Period Certain

Payments continue for the annuitant's lifetime, with a guaranteed minimum period (e.g., 10 or 20 years). If the annuitant dies before the period ends, payments continue to beneficiaries.

• Advantage: Guarantees a minimum payout regardless of when death occurs
• Disadvantage: Lower monthly payment than life only
• Best for: Those concerned about dying shortly after annuitization

Joint and Survivor

Payments continue for two lives (typically spouses). After the first death, payments continue to the survivor, often at a reduced rate (e.g., 50%, 75%, or 100% of the original payment).

• Advantage: Provides income for surviving spouse
• Disadvantage: Lower initial payment than single life options
• Best for: Married couples dependent on annuity income

Refund Annuity

Guarantees that at least the total premium paid will be returned. If the annuitant dies before receiving payments equal to the premium, the difference is paid to beneficiaries.

• Installment refund: Beneficiary receives remaining balance in installments
• Cash refund: Beneficiary receives remaining balance as lump sum

Key Concepts Summary