5.2 Annuities
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10% penalty on earnings withdrawn before age 59½.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 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:
| 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: $100,000 ÷ $200,000 = 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?
Tax-free
Taxed as capital gains only
Taxed as ordinary income plus 10% penalty
Taxed at 15% flat rate
Under LIFO taxation, which portion of an annuity is withdrawn first?
Principal (cost basis)
Earnings (gains)
Half principal, half earnings
Contract owner chooses
Which annuity payout option provides the HIGHEST periodic payment?
Life with 10-year period certain
Joint and survivor
Life only (straight life)
20-year period certain
A variable annuity is considered a security because:
It is sold by insurance companies
It provides a death benefit
The cash value is invested in a separate account with market risk
It offers tax-deferred growth
Sections you finish are checked off in the contents.