6.3 Deferred and Indexed Annuities

Deferred annuities and tax deferral

A deferred annuity has a real accumulation phase: deposits grow free of current income tax until the owner withdraws money or annuitizes. This tax deferral is the central selling point — earnings compound without an annual tax drag. It is deferral, not exemption: gains are eventually taxed as ordinary income, never as capital gains, regardless of how long the contract was held.

Deferred annuities come in single-premium (SPDA) and flexible-premium (FPDA) forms. Both build a cash value the owner can access before annuitization through partial withdrawals or full surrender.

LIFO withdrawal rule

For any nonqualified annuity issued after August 13, 1982, withdrawals are taxed LIFO — last in, first out. Because earnings are credited on top of principal, withdrawals are deemed to come from interest/earnings first, which are fully taxable, and only later from tax-free basis. There is no tax-favored "basis-first" withdrawal from these contracts.

The 10% premature-distribution penalty

Because annuities are retirement vehicles, the IRS adds a 10% federal penalty on the taxable portion of distributions taken before age 59½, on top of ordinary income tax. Common exceptions to the penalty include death, disability, and payments taken as a series of substantially equal periodic payments (annuitization for life).

Worked example

Dev, age 50, owns a deferred annuity with $80,000 of basis and $40,000 of gain (total $120,000). He withdraws $30,000.

• Under LIFO, the first $40,000 of any withdrawal is gain, so the entire $30,000 is taxable ordinary income.
• Because he is under 59½, a 10% penalty also applies: $30,000 × 10% = $3,000.
• He keeps only what remains after income tax plus the $3,000 penalty.

Surrender charges, free withdrawals, and nonforfeiture

Deferred annuities impose surrender charges (a back-end load / contingent deferred sales charge) to discourage early termination and let the insurer recover acquisition costs. A typical schedule declines each year until it reaches zero.

• A free-withdrawal provision lets the owner take a set amount each year (commonly 10% of the account value) with no surrender charge.
• The nonforfeiture (bailout) guarantee sets a minimum surrender value the owner is always entitled to — typically a minimum percentage of premiums credited with a minimum interest rate.

Example

A $50,000 account in year 2 (6% charge) with a 10% free-withdrawal corridor: the owner may take $5,000 charge-free; an additional $10,000 withdrawn would incur 6% on the excess = $600.

Equity-indexed annuities (EIA / FIA)

An equity-indexed annuity (also fixed-indexed annuity) is a fixed annuity whose interest is linked to a stock-market index such as the S&P 500, but with a guaranteed minimum floor (often 0–3%) so the owner cannot lose principal to market declines. It is still an insurance product — premiums sit in the general account and it usually requires only an insurance license (a securities license is required only if the specific product is registered).

Three levers limit how much index gain is actually credited:

• Participation rate — the percentage of the index's gain the contract credits. At an 80% participation rate, a 10% index gain credits 8%.
• Cap rate — a maximum credited rate. With a 6% cap, even a 20% index gain credits only 6%.
• Spread / margin / asset fee — a percentage subtracted from the index gain. A 2% spread on a 10% gain credits 8%.

Worked example

Index rises 12%. The contract has an 80% participation rate and a 7% cap.

• Apply participation: 12% × 80% = 9.6%.
• Apply the cap: 9.6% exceeds the 7% cap, so the credited rate is 7%.

If the index had fallen, the floor (say 1%) would apply and the owner would still be credited 1% — never a negative return.

Surrender Charges and the Free-Look Window

Deferred annuities almost always carry a declining surrender-charge schedule that the exam expects you to read. A typical schedule charges 7% of the amount withdrawn in year one, 6% in year two, and so on down to 0% after seven or eight years, with a penalty-free withdrawal corridor of usually 10% of value per year. Work a case: an owner with $100,000 in a deferred annuity in its third surrender year (5% charge) withdraws $30,000.

The first $10,000 is within the 10% free corridor and escapes the charge; the remaining $20,000 incurs a 5% surrender charge of $1,000, plus, if the owner is under 59 1/2, a 10% IRS penalty on the taxable gain portion. This stacking of insurer surrender charge and IRS penalty is a favorite exam trap.

Deferred annuities also carry a market value adjustment in many fixed designs, raising or lowering the surrender value as interest rates move, and a bonus or first-year-rate feature that the exam flags as potentially misleading if the bonus is recaptured through higher charges. Equity-indexed annuities add their own crediting nuances: the participation rate, cap, and floor interact with the chosen indexing method (annual reset, point-to-point, or high-water mark), and an annual reset locks in each year's gain so a later downturn cannot erase it.

The free-look provision lets the owner return a new annuity within a stated period, often 10 to 30 days, for a full refund, and a replacement annuity typically receives the longer free-look window, mirroring the consumer protections that apply to life insurance replacement.