Annuities — plain-language explainer
Definition
– An annuity is a contract sold by an insurance company that converts premiums you pay (either as a lump sum or as periodic payments) into a stream of future cash payments. The person who owns or receives the payments is the annuitant.
– Key terms: accumulation phase (when your money is growing inside the contract); payout phase (when the insurer sends you income). A surrender period is a time window during which withdrawals usually trigger extra fees.
Why people buy annuities
– Main goal: provide a predictable income stream in retirement and reduce the risk of outliving your savings (longevity risk).
– Typical buyers: retirees or people approaching retirement who want guaranteed income, or anyone who has a large lump sum and prefers steady payments instead of spending the principal.
Basic types (short definitions)
– Immediate annuity: Starts paying income almost right away after a lump-sum purchase. Often used to turn a large sum (e.g., from a settlement) into regular cash flows.
– Deferred annuity: Accumulates value over time (tax-deferred) and begins income payments at a future date you select.
– Fixed annuity: The insurer credits a stated return or pays a fixed income; regulated by state insurance authorities.
– Variable annuity: Your account value depends on underlying investments (subaccounts); regulated by the Securities and Exchange Commission (SEC) and state insurance regulators.
– Indexed annuity: Interest crediting is linked to a market index; regulatory treatment depends on structure—sometimes treated like a security.
How an annuity works (step-by-step)
1. Purchase: You pay premiums (one-time lump sum or regular payments).
2. Accumulation (if deferred): Money grows inside the contract, typically tax-deferred.
3. Election: You choose when and how to convert the accumulated value to payouts (immediate vs. deferred payout start; single or joint life options; period-certain guarantees).
4. Payouts: The insurer pays according to the contract—either for a set term or for life (yours or you+survivor).
5. Surrender/secondary market: During the surrender period, withdrawals often incur charges. Some owners sell future payments to third parties (give up future income for a lump sum).
Regulation and selling practices (what to know)
– Variable and certain registered indexed annuities are treated as securities (SEC oversight); FINRA also enforces rules for broker-dealers and sales practices.
– Fixed and most unregistered indexed annuities are regulated by state insurance commissioners.
– Producers who sell annuities normally need a state life-insurance license; if the annuity is a security (variable), they also need a securities license. Commissions for sellers are typically tied to the contract’s notional value.
Important contractual features and practical effects
– Surrender period: Many annuities impose a multi‑year surrender period. Early withdrawals can trigger surrender charges. A common industry practice is to permit a penalty-free annual withdrawal of up
up to a stated percentage of the contract value each year (commonly 5%–10%) without triggering surrender charges. Any withdrawals above that allowance during the surrender period typically incur a declining schedule of surrender charges (for example: 8% year 1, 7% year 2, …, 0% year 8). Surrender charges and penalty‑free withdrawal rules vary by contract—read the schedule carefully.
– Riders (optional guarantees): Many annuities offer riders—contract add‑ons that change benefits or risks. Common riders include guaranteed minimum income benefits (GMIB), guaranteed lifetime withdrawal benefits (GLWB or GMWB), enhanced death benefits, and long‑term care hybrids. Riders increase cost (via explicit rider fees or higher spreads) and often have extra conditions.
– Annuitization: Annuitization means converting the accumulated value into a stream of periodic payments. Payment options include period certain (fixed number of years), life only (payments for the annuitant’s life), or joint and survivor (payments while at least one person lives). Once annuitized in many contracts, the choice is irreversible.
– Death benefit: Most contracts return some death benefit to beneficiaries if the annuitant dies before annuitization. The form and taxation of the death benefit depend on whether the annuity is qualified (funded with pre‑tax retirement money) or non‑qualified (funded with after‑tax money).
– Tax treatment and early‑withdrawal penalties: Accumulation is tax‑deferred. For non‑qualified annuities (after‑tax dollars), withdrawals are generally taxed under the last‑in, first‑out (LIFO) rule: earnings are treated as withdrawn first and are taxable as ordinary income; only after earnings are exhausted do withdrawals become a return of principal (non‑taxable). For qualified annuities (IRAs, 401(k) rollovers), withdrawals are typically fully taxable as ordinary income. Distributions before age 59½ may be subject to an additional 10% federal penalty unless an exception applies.
Taxation — brief numeric examples and rules
– LIFO example (non‑qualified annuity): Basis (after‑tax premiums) = $50,000. Contract value = $120,000 (so earnings = $70,000). If you take a $20,000 taxable withdrawal, under LIFO the entire $20,000 is treated as taxable earnings (ordinary income). If you instead take a full surrender of $120,000, $70,000 is taxable ordinary income and $50,000 is return of basis (non‑taxable
Taxation — continued: annuitization and death benefits
– Taxation on annuitization (converting contract value into a stream of payments). For non‑qualified annuities (bought with after‑tax dollars), the payments you receive after annuitization are divided into a taxable portion (return of earnings) and a non‑taxable portion (return of basis). If you choose a “period certain” or fixed‑term annuity, use the exclusion ratio to calculate the non‑taxable portion: exclusion ratio = investment in the contract ÷ expected return (total payments expected over the payout period). The non‑taxable amount each year = exclusion ratio × annual payment. For lifetime payouts the exclusion ratio is computed using life expectancy tables; IRS Publication 575 provides guidance.
– Death benefits and beneficiary taxation. If a beneficiary receives the remaining contract value of a non‑qualified annuity in a lump sum, the earnings portion is taxed as ordinary income (LIFO rules still apply to the deceased owner’s withdrawals before payout). If the beneficiary inherits the contract and keeps it, taxation depends on whether they take distributions over time or in a lump sum; required minimum distribution rules and estate tax considerations may apply.
Common fees and costs (what to watch for)
– Surrender charges: Early withdrawals above free‑withdrawal allowances often incur surrender charges that typically decline over a multi‑year schedule (e.g., 7% year 1 down to 0% year 7).
– Mortality and expense (M&E) fees: Variable annuities commonly charge an M&E fee (e.g., 0.5%–1.5% annually) to cover guarantees and insurer costs.
– Administrative fees: Flat annual fees for contract maintenance (often $25–$100).
– Investment management fees: For variable annuities, subaccounts charge fund management fees; total expense ratios affect net returns.
– Rider costs: Optional guarantees (income riders, enhanced death benefits) carry additional fees, often as a percentage of contract value (commonly 0.25%–1.25%).
– Cap/spread/index margin: Indexed annuities credit gains using a formula (cap, spread, or participation rate) that limits upside; read the crediting method carefully.
Liquidity and surrender considerations
– Most annuities are illiquid for a number of years because of surrender schedules and penalties.
– Contracts usually permit a penalty‑free withdrawal each year (commonly 10% of contract value).
– Emergency access riders and penalty‑free withdrawals for certain events (e.g., nursing home confinement) may be available but can add cost.
Riders and guarantees — practical checklist
– Does the contract offer a guaranteed lifetime withdrawal benefit (GLWB)? If so, what is the guaranteed withdrawal percentage and how is it earned (roll‑up rate, bonus)?
– Is there a guaranteed minimum accumulation benefit (GMAB) or guaranteed minimum income benefit (GMIB)?
– Are riders added for an extra fee? What is that fee in percentage points and how is it assessed (on full account value or only on benefit base)?
– How does the rider treat withdrawals, transfers, and annuitization for benefit eligibility?
– Are there exclusions or conditions that void benefits (e.g., market value adjustments, excessive withdrawals)?
Worked numeric example — deferred fixed annuity accumulation and annuitization
Assumptions:
– Single premium = $100,000 (after tax), credited guaranteed interest = 3% annually, accumulation period = 10 years.
– After 10 years contract value = 100,000 × (1.03)^10 = 134,392 (rounded).
– Suppose you annuitize into a 15‑year certain fixed payout and the insurer uses an interest rate of 3% to compute payments.
Compute level annual payment (ordinary annuity formula):
– PMT = PV × r / [1 − (1 + r)^−n]
– PV = 134,392; r = 0.03; n = 15
– Denominator = 1 − (1.03)^−15 ≈ 1 − 0.642 = 0.358
– PMT ≈ 134,392 × 0.03 / 0.358 ≈ 4,031 / 0.358 ≈ $11,257 per year
Tax treatment:
– Use exclusion ratio: investment in contract (basis) = $100,000; expected return = PMT × n = 11,257 × 15 = 168,855.
– Exclusion ratio = 100,000 / 168,855 ≈ 0.592. Non‑taxable portion per year ≈ 0.592 × 11,257 ≈ $6,666. Taxable portion ≈ $4,591 (ordinary income).
Common risks and tradeoffs
– Inflation risk: Fixed payouts lose purchasing power over time; inflation riders can offset this but reduce initial income.
– Credit risk: Guarantees depend on the issuing insurer’s financial strength. State guaranty associations provide limited protection if the insurer fails; coverage limits vary by state.
– Opportunity cost: Money in an annuity is not available for other investments or for tax‑advantaged accounts unless structured that way.
– Complexity and fees: Some annuities, especially variable and indexed, can be complex; fees can materially reduce net returns.
How to evaluate and buy an annuity — step‑by‑step checklist
1. Define the objective: retirement income, legacy, tax deferral, or guaranteed lifetime income.
2. Decide product type: immediate vs deferred; fixed, fixed indexed, or variable.
3. Check insurer strength: review credit ratings from A.M. Best, S&P, or Moody’s.
4. Compare costs: surrender schedule,
surrender charges, mortality and expense fees (for variable annuities), rider costs, and administrative fees. Ask for an itemized fee schedule and examples showing how fees reduce projected payouts.
5. Ask for illustrations and scenarios: Get firm, dated illustrations for conservative, base, and optimistic crediting or investment return scenarios. For indexed annuities, demand the exact index crediting method and caps/spreads used in each illustration.
6. Confirm surrender terms and liquidity: Note the length of the surrender period, the percentage charge by year, any free-withdrawal provisions, and hardship or nursing-home waivers. Verify how GMWB (guaranteed minimum withdrawal benefit) riders interact with surrender charges.
7. Understand taxes and reporting: Determine whether the annuity will be held inside a qualified plan (IRA/401(k)) or bought with after‑tax (non‑qualified) dollars. For non‑qualified annuities, withdrawals are generally taxed under the LIFO (last in, first out) rule—earnings withdrawn first and taxed as ordinary income. For qualified annuities, distributions are typically fully taxable. Ask your tax advisor for personalized tax consequences.
8. Check insurer creditworthiness and state protections: Review ratings from A.M. Best, S&P, or Moody’s and check state guaranty association limits (coverage varies by state). Ensure you are comfortable with the counterparty risk.
9. Read the contract carefully before signing: Confirm guaranteed amounts, indexing rules, withdrawal rules, death-benefit description, escalation clauses, and the exact language around lifetime income guarantees. If anything is unclear, get written clarification.
10. Get independent advice for complex products: If you’re considering variable or indexed annuities with riders, consider independent fee-only financial advice or a fiduciary review. Keep documentation of illustrations and the advisor’s recommendations.
Quick math — common formulas and worked examples
Below are a few practical formulas for basic annuity math. Assume payments occur at regular intervals and rates are per period. Always check whether payments are beginning-of-period (annuity due) or end-of-period (ordinary annuity); formulas below assume end‑of‑period unless stated.
A. Fixed‑term immediate annuity (payments for n periods)
– Present value of an ordinary annuity (annuity factor):
a_n = (1 − (1 + r)^−n) / r
– Payment given principal PV:
PMT = PV × r / (1 − (1 + r)^−n)
Worked example:
You have $100,000 and buy a 20‑year immediate fixed annuity; contract-equivalent interest rate (market rate used by insurer) = 4% annually.
PMT = 100,000 × 0.04 / (1 − (1.04)^−20) ≈ 100,000 × 0.04 / (1 − 0.45639) ≈ 4,000 / 0.54361 ≈ $7,362 per year.
Assumptions: insurer uses the same 4% rate for pricing; this ignores insurer profit margins, fees included in price, and mortality credits used in life annuities.
B. Accumulation with periodic contributions (future value)
– FV of level contributions PMT for n periods at rate r:
FV = PMT × ((1 + r)^n − 1) / r
Worked example:
Contribute $5,000 at year-end for 20 years with annual return 6%:
FV = 5,000 × ((1.06)^20 − 1) / 0.06 ≈ 5,000 × (3.207135 − 1) / 0.06 ≈ 5,000 × 36.7856 ≈ $183,928.
C. Rough life‑annuity estimate (crude)
For lifetime annuities, actuaries use mortality tables to compute the annuity factor. As a back‑of‑envelope, you can approximate:
PMT ≈ PV / expected remaining years
Worked example:
$200,000, expected remaining years 25 → PMT ≈ 200,000 / 25 = $8,000 per year.
This ignores mortality credits (pooling of longevity risk), insurer costs, and differing payment timing; use only as a quick estimate.
D. Fee drag for variable/indexed annuities (illustrating impact)
If gross investment return = Rg and total fees = f, net return Rn = Rg − f. Future value over n years:
FV = PV × (1 + Rn)^n
Example:
$100,000, gross return 6%, fees 2% → net 4%, 20 years:
FV_net = 100,000 × 1.04^20 ≈ 100,000 × 2.191 ≈ $219,100.
If fees were 1% → net 5% → FV ≈ 100,000
× 1.05^20 ≈ 100,000 × 2.653 ≈ $265,300. The difference between the two fee scenarios after 20 years is roughly $265,300 − $219,100 ≈ $46,200 — a clear example of fee drag compounding over time.
E. More accurate annuitization math (payments from a fixed/purchased annuity)
– For a level (fixed) payout annuity with n payments and interest rate r, the present value (PV) formula for an ordinary annuity (payments at period end) is:
PV = PMT × [1 − (1 + r)^−n] / r
Solving for the payment (PMT):
PMT = PV × r / [1 − (1 + r)^−n]
Worked numeric example (contrast with the simple division shortcut):
– Suppose PV = $200,000, r = 3% (0.03), n = 25 years.
Denominator: 1 − (1.03)^−25 ≈ 1 − 0.476 = 0.524
Numerator: 200,000 × 0.03 = 6,000
PMT ≈ 6,000 / 0.524 ≈ $11,450 per year
– Compare to the back‑of‑envelope PMT ≈ PV / years = $200,000 / 25 = $8,000. Interest matters: if r > 0, the precise formula yields a larger annual payment than the naive division because part of each payment comes from investment earnings.
F. Mortality credits (brief)
– Mortality credits = the additional payments survivors receive because the pooled capital of deceased participants is redistributed to living annuitants. This pooling of longevity risk is why lifetime annuities typically pay more than a self-managed systematic withdrawal of the same capital (all else equal).
– Mortality credits are present only in pooled/lifetime annuities and depend on actual longevity experience of the pool.
G. Common annuity costs and how they reduce returns
– Up‑front or ongoing charges you’ll typically see:
1. Mortality & expense (M&E) charge — covers insurer guarantees and costs (variable annuities).
2. Subaccount/management fees — for investment options inside variable annuities.
3. Rider fees — optional guarantees (e.g., guaranteed minimum withdrawal benefit, GMIB; guaranteed lifetime withdrawal benefit, GLWB).
4. Administrative fees and contract maintenance fees.
5. Surrender charges — penalties for early withdrawals within a surrender period (commonly 5–15 years).
– Practical step: express each fee as a percentage and subtract from expected gross return to get net return (Rn = Rg − f). Then compute FV or PV with the net rate to compare scenarios.
H. Liquidity, surrender schedules, and sequence-of-withdrawal rules
– Many annuities restrict access to principal in early years via surrender charges or penalties.
– Variable/Indexed annuities often allow a limited “free withdrawal” each year (e.g., 10% of account value) without charge—confirm specifics.
– Systematic withdrawal vs annuitization decision: annuitizing converts account value into a guaranteed income stream (often irreversible). If maintaining liquidity is important, consider non‑annuitized options or shorter surrender periods.
I. Tax treatment (key rules)
– Nonqualified annuity (funded with after‑tax dollars):
– Growth is tax‑deferred while invested.
– Withdrawals are taxed under last-in, first-out (LIFO): earnings are withdrawn (and taxed as ordinary income) before basis until earnings are exhausted.
– If you annuitize, use the exclusion ratio to determine the tax‑free portion of each payment for your expected return period.
– Early withdrawal penalty: earnings withdrawn before age 59½ may incur a 10% IRS penalty plus ordinary income tax on earnings.
– Qualified annuity (funded with pre‑tax dollars, e.g., IRA):
–
– Qualified annuity (funded with pre‑tax dollars, e.g., traditional IRA or 401(k)):
– Contributions were tax‑deductible or made with pre‑tax employer money, so the contract basis is effectively zero for income‑tax purposes.
– Growth is tax‑deferred while invested.
– Distributions (whether lump sums, systematic withdrawals, or annuity payments) are taxed as ordinary income to the extent they represent earnings or return of pre‑tax principal. In practice, for most qualified annuities the entire distribution is taxable.
– If you annuitize a qualified contract, each payment is generally fully includible in taxable income (the exclusion ratio that applies to nonqualified contracts normally does not produce a tax‑free portion).
– Early‑withdrawal penalties (10% additional tax) can apply to taxable distributions taken before the applicable age threshold (generally 59½, subject to IRS rules and exceptions).
– Required minimum distribution (RMD) rules for qualified retirement accounts apply to annuities held inside IRAs/401(k)s; consult current IRS guidance on RMD ages and calculations.
II. How to compute tax on withdrawals — practical steps and worked examples
A. Nonqualified annuities (after‑tax basis) — LIFO rule for withdrawals
– Key rule: Withdrawals from nonqualified annuities follow the IRS last‑in, first‑out (LIFO) ordering for taxable treatment: earnings are treated as distributed before return of basis. Only after all earnings are withdrawn are basis (your after‑tax contributions) returned tax‑free.
– Step‑by‑step (lump or systematic withdrawals):
1. Determine contract value and total basis (sum of after‑tax premiums).
2. Compute earnings = contract value − basis.
3. For any withdrawal amount up to the earnings balance, treat that portion as ordinary income.
4. Once earnings are exhausted, subsequent withdrawals are treated as a tax‑free return of basis until basis is used up.
5. Track remaining basis and earnings after each withdrawal (company statements should show this).
Worked numeric example (nonqualified):
– You paid $50,000 (basis) into an annuity; it has grown to $80,000. Earnings = $30,000.
– If you withdraw $20,000 in Year 1: under LIFO, the entire $20,000 is treated as taxable ordinary income (it comes from earnings). After withdrawal: contract value = $60,000; remaining earnings = $10,000; basis still $50,000.
– If you withdraw another $25,000 in Year 2: $10,000 is taxable (the remaining earnings) and $15,000 is a tax‑free return of basis.
B. Annuitization and the exclusion ratio (nonqualified contracts