An annuity is the mirror image of life insurance. Life insurance builds an estate at death and protects against dying too soon; an annuity systematically liquidates a sum during life and protects against living too long. This guide covers the parties, the accumulation and payout phases, fixed, variable, and indexed annuities, immediate vs. deferred contracts, payout options, surrender charges and riders, the NAIC disclosure and best-interest rules, and the key federal tax rules.

The parties

• Owner – buys and controls the contract: makes withdrawals, names the beneficiary, chooses the payout. The owner may be a person or an entity.
• Annuitant – the measuring life whose age and life expectancy determine the payments. The annuitant must be a natural person. Often the same as the owner.
• Beneficiary – receives the death benefit if the owner or annuitant dies before annuitization.
• Insurer – holds the funds and guarantees the promised payments.

Accumulation and annuitization

• Accumulation phase – premiums are paid in and earnings grow tax-deferred.
• Annuitization (payout) phase – the owner converts the accumulated value into a series of income payments. Once annuitized, the contract is generally no longer surrendered for a lump sum.

Funding:

• Single premium – one lump-sum payment.
• Flexible premium – varying deposits over time (flexible premium deferred annuity).

Immediate vs. deferred

• Immediate annuity (SPIA) – bought with a single premium; income begins within one payment interval (within a year) of purchase. Used to turn a lump sum into income now, and to fund structured settlements that pay an injury award as periodic payments.
• Deferred annuity – income begins at a future date, after tax-deferred accumulation. It has a cash surrender value during accumulation.
• Longevity (deferred income) annuity – buys lifetime income starting at an advanced age. A qualified longevity annuity contract (QLAC) inside a retirement plan can defer income to as late as age 85 and lowers required minimum distributions on that amount.

Fixed, variable, and indexed annuities

Fixed annuity

The insurer guarantees principal, a minimum interest rate, and income at stated rates. Money is in the insurer's general account, so the insurer bears the investment risk. State nonforfeiture law (NAIC Model #805) requires a deferred annuity to provide a guaranteed minimum value. A bailout provision waives surrender charges if the credited rate falls below a set level.

Variable annuity

Premiums go to a separate account and buy accumulation units in subaccounts the owner chooses; the owner bears the investment risk. At annuitization, accumulation units convert to annuity units. Each payment is benchmarked against the assumed interest rate (AIR): if the separate account earns more than the AIR, the next payment rises; if less, it falls.

Variable annuities are securities: SEC-registered, sold with a prospectus, by producers with a life license and FINRA registration. Common guarantees:

• Guaranteed minimum death benefit (GMDB) – the beneficiary gets at least premiums paid (less withdrawals) even if the account fell.
• Guaranteed minimum income benefit (GMIB) – a floor on annuitized income.
• Guaranteed minimum withdrawal benefit (GMWB) – a set annual withdrawal even if the account value falls.

Fixed indexed annuity

Interest is credited based on a market index, within limits:

• Cap – the maximum rate credited. With a 6% cap, a 9% index gain credits 6%.
• Participation rate – the share of the gain used. 60% participation on a 10% gain = 6%.
• Spread (margin) – subtracted from the gain. A 7% gain with a 2% spread credits 5%.
• Floor – usually 0%, so index losses don't reduce the value.

Crediting methods include annual reset (ratchet), which locks in each year's gain; point-to-point, which compares two dates; and high-water mark, which uses the highest anniversary value. Fixed indexed annuities are insurance products regulated under state law (Dodd-Frank Section 989J) and sold under a life license; only annuities registered as securities fall under SEC and FINRA rules.

Payout options

Surrender charges and contract features

• Surrender charges apply to withdrawals above the free amount during the early contract years and typically decline to zero. They are separate from any IRS penalty.
• Free withdrawal provision – many contracts allow about 10% a year without a surrender charge.
• Market value adjustment (MVA) – changes the surrender value based on interest-rate movement since issue: generally lower if rates have risen, higher if they have fallen.
• Bonus annuities credit extra in the first year but usually carry longer or higher surrender charges.
• Nursing home waivers in many contracts waive surrender charges for qualifying confinement.
• A two-tier annuity credits a higher value that is available only by annuitizing.
• A split annuity pairs an immediate annuity for income with a deferred annuity to rebuild principal.
• Death benefit – most deferred annuities pay the beneficiary at least the contract value or premiums paid if the owner dies before annuitization.
• Free look – the owner may return the contract for a refund within the period set by state law; under NAIC Model #245, at least 15 days if the disclosure document and Buyer's Guide weren't given at or before application.

Disclosure and best interest

• Annuity Disclosure Model Regulation (#245) – the applicant receives a disclosure document and the annuity Buyer's Guide.
• Suitability in Annuity Transactions Model Regulation (#275, 2020 revision) – the producer must act in the consumer's best interest (care, disclosure, conflict of interest, documentation), gather the consumer profile (age, income, financial situation, objectives, time horizon, liquidity needs, risk tolerance, tax status), and complete a one-time 4-credit annuity course plus product training. For replacements, the producer weighs surrender charges, lost benefits, fees, and any exchange in the past 60 months.

A deferred annuity with a long surrender period is a poor fit for someone who may need the money soon, such as a retiree facing medical bills.

Group and qualified annuities

• A qualified annuity funds an IRA or employer plan with pre-tax dollars; distributions are fully taxable.
• 403(b) tax-sheltered annuities serve public school and 501(c)(3) employees.
• Group annuities fund employer pension benefits under a master contract.

Federal tax rules

• Tax-deferred growth – earnings aren't taxed until withdrawn or annuitized.
• Withdrawals from a nonqualified deferred annuity (for investments after August 13, 1982) come out earnings first (LIFO) and are taxed as ordinary income until the gain is exhausted.
• 10% additional tax on taxable amounts withdrawn before 59½, with exceptions such as death, disability, substantially equal periodic payments, and immediate annuities (IRC 72(q)).
• Exclusion ratio at annuitization: investment in the contract ÷ expected return = tax-free share of each payment. Example: $100,000 ÷ $250,000 = 40%, so $10,000 of a $25,000 payment is tax-free and $15,000 is taxable. Once basis is fully recovered, later payments are fully taxable.
• Owner's death before annuitization (IRC 72(s)) – a non-spouse beneficiary must take the entire interest within 5 years or as life-expectancy payments beginning within 1 year; a surviving spouse may continue the contract as owner.
• No step-up in basis – the beneficiary pays ordinary income tax on the gain.
• Non-natural owners – a deferred annuity held by a corporation for its own benefit loses tax deferral (IRC 72(u)).
• Section 1035 allows tax-free exchanges of annuity to annuity (and life to annuity), but not annuity to life.

Common exam traps

• Annuities protect against outliving your money; life insurance protects against dying too soon.
• Fixed annuity: insurer bears investment risk. Variable: owner bears it.
• Variable annuities need FINRA registration; fixed indexed annuities are state-regulated insurance.
• Life only pays the most but leaves nothing to heirs; adding guarantees lowers each payment.
• Cash refund = lump sum; installment refund = continued payments.
• Joint life stops at the first death; joint and survivor continues to the second.
• Payments above the AIR rise; below it, they fall.
• Nonqualified withdrawals are LIFO (earnings first); annuities get no step-up at death.
• Surrender charges (insurer) are different from the 10% additional tax (IRS).

Quick recap

• Parties: owner, annuitant (measuring life), beneficiary, insurer.
• Phases: accumulation (tax-deferred) and annuitization (income).
• Immediate income starts within a year; deferred starts later.
• Fixed (insurer's risk), variable (owner's risk, AIR, accumulation/annuity units, securities rules), indexed (caps, participation, spreads, floors; state-regulated).
• Payout options trade income size for guarantees.
• Model #245 disclosure and Model #275 best interest govern annuity sales.
• Taxes: LIFO withdrawals, 10% before 59½, exclusion ratio, 5-year rule at the owner's death, no step-up.