Section 4.6 — Annuities

  • What is an Annuity?

  • Qualified vs Nonqualified Accounts

  • Phases and Types of Annuities

1. What is an Annuity?:

  • An annuity is a contract with a life insurance company designed to provide retirement income.

  • It pays a stream of income for a certain period — often for the life of the annuitant (the insured person).

  • There is no contribution limit — investors can put in as much as they want.

2. Qualified vs Nonqualified Accounts:

  • Nonqualified accounts are funded with after-tax dollars (money that has already been taxed).

  • Earnings grow tax-deferred during the accumulation phase, and taxes are paid only when money is withdrawn.

  • This is different from qualified retirement plans (like IRAs or 401(k)s), which are funded with pre-tax money and have IRS contribution limits.

3. Phases of an Annuity

Phase / Description / Tax Treatment

  • Accumulation Phase / Investor makes deposits (premiums). Money grows tax-deferred. / No taxes until withdrawn.

  • Annuity (Payout) Phase / Investor begins receiving income payments. / Each payment = part taxable income + part tax-free return of principal (exclusion ratio).

4. Types of Annuities

Feature / Fixed Annuity / Variable Annuity

  • Security Status / Not a security / Is a security Investment

  • Risk / Taken by insurance company / Taken by investor

  • Underlying Investment / Insurance company’s general account / Separate account with subaccounts (like mutual funds)

  • Return / Fixed rate guaranteed / Fluctuates with performance of subaccounts

  • Inflation Risk / Yes (payout may not keep up with inflation) / No fixed risk; may outpace inflation

  • Market Risk / None / Yes

  • Licenses to Sell / Life insurance license / Life insurance + securities license  

  • Payment in Retirement / Fixed, guaranteed / Variable — depends on separate account performance vs AIR

  • Who Bears Investment Risk / Insurance company / Investor

  • Suitability / Conservative investor seeking stability / Long-term investor seeking inflation protection

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5. Key Concepts in Variable Annuities (VA):

  • Separate Account: Investment portion of the VA, operates like an investment company (UIT or open-end fund).

  • Subaccounts: Individual investment choices within the separate account (stocks, bonds, etc.).

  • Regulated under: Investment Company Act of 1940.

  • Disclosure: Fees must be disclosed — administrative, advisory, custodial, and surrender charges.

6. Variable Annuity Phases:

  • Accumulation Phase:

    • Contributions grow tax-deferred.

    • If the annuitant dies, the beneficiary receives the greater of:

      • Account value, or

      • Total premiums paid.

  • Annuity Phase:

    • Investor annuitizes — gives up ownership for lifetime income.

    • One-time, irreversible decision.

7. Annuitization & Payout Factors:

  • Payment amount is based on S.A.A.P.I:

    • S – Sex of annuitant

      A – Age of annuitant

      A – Amount of annuity

      P – Payout option selected

      I – Assumed Interest Rate (AIR)

8. AIR (Assumed Interest Rate):

  • AIR is the benchmark rate used to project future payments.

  • After the first payment, future payments depend on separate account performance vs AIR:

    • Above AIR → payments increase

    • Below AIR → payments decrease

    • Equal AIR → payments stay the same

  • Payments never drop to zero.

9. Suitability for Variable Annuities:

  • Designed for retirement income, not short-term goals (like education or home purchase).

  • Should not be funded by:

    • Existing retirement plan assets

    • Borrowed money or home equity

    • Life insurance policy cash-outs

  • Should be funded with available cash and only after maximizing qualified retirement plans.

  • Must have the risk tolerance for market fluctuations.

10. Taxation Rules:

  • Tax-deferred growth: No taxes until withdrawn.

  • Withdrawals:

    • Annuitization: Each payment = principal (non-taxable) + earnings (taxable).

    • Lump Sum Withdrawal: Entire earnings portion taxable as ordinary income.

    • Partial Withdrawal: LIFO (Last In, First Out) — earnings withdrawn first (taxable), then principal (non-taxable).

  • Early Withdrawal (Before Age 59½):

    • 10% IRS penalty applies to taxable portion only.

📄 1035 Exchange:

  • Allows tax-free transfer from one annuity to another.

  • Similar to a rollover, avoids immediate taxation on gains.

11. Exclusion Ratio Example:

  • Investor deposits $300,000, account grows to $500,000.

    Exclusion Ratio = Principal / Total Value = ($300,000 / $500,000) = 60%

    Monthly payment = $2,000

    • $1,200 (60%) → Return of principal (not taxable)

    • $800 (40%) → Taxable income

Chapter 5

✺ Review questions ✺

  • A stream of retirement income.

  • Nonqualified (funded with after-tax dollars).

  • Accumulation phase and annuity (payout) phase.

  • The insurance company.

  • The investor.

  • Sex, Age, Amount, Payout option, Assumed Interest Rate (S.A.A.P.I.).

  • Payments increase.

  • Last In, First Out — earnings withdrawn first and taxed first.

  • 10% penalty on the taxable portion

  • A tax-free transfer from one annuity to another.

  • $800 taxable, $1,200 tax-free.