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Annuities

Updated: February 20, 2024

Annuities are one of the ways to receive income when you are retired. It is  long-term agreement in which you (the owner or annuitant) transfer property or assets to a person or company (the obligor) in return for regular payments to you. Most annuities are protected from probate court, estate taxes, and creditors.

Annuities are essentially insurance that can protect you from the risk of outliving your assets. One of the drawbacks of this security is that the return on investment of annuities is usually less than other investment choices. Often referred to as opportunity cost, it is the amount of potential gain you miss out on when you commit to one investment choice over another.

You typically purchase annuities from a life insurance or investment company, but they are sometimes available from financial advisors, banks, brokerage firms, and mutual fund companies. Setting up most annuities is expensive, those sold by traditional insurance companies through insurance agents even more so.

  • Most of the cost comes from commissions and fees — typically 1%-10% of the contract value — charged by those involved, which may include property assessors, accountants, actuaries, and insurance agents.
  • The more professionals involved, the higher the investment risk, and the more complex the terms of the annuity, the more expensive the set-up charge. For example, calculating a variable annuity payment is much more complex than a fixed annuity payment and, therefore, more expensive.
  • The cost will also increase for each rider/provision you add. Increasing the number of guarantees/provisions/riders will also decrease payments.
  • Low-cost annuities may be available through financial companies.

The earnings from the annuity (capital gains, dividends, and interest) accumulate tax-free.

Like a 401(k), you must be at least 59½ years old to begin withdrawals without penalties. Once this starts, you will get payments for a specific time, usually the rest of your life. How the withdrawals are taxed, how much can be invested, and how long you can defer withdrawals are based on whether the annuity was funded with pre-tax or after-tax dollars.

The differences between funding your annuity with pretax (Qualified Annuity) or after-tax money (Non-Qualified Annuity).

 

Qualified Annuities

Non-Qualified Annuities

Funding

Funded with pretax dollars or assets created with them, such as an IRA, or a 401K 

Funded with after-tax dollars or assets created with them, such as savings, stocks, and other investments

Annual limit adding funds

Yes

No

Age at which withdrawals must begin

70½ years old

No limit

Withdrawal income taxed as ordinary income

Total withdrawal, even money that was withdrawn before 59½ years old for which you paid a surrender fee

Earned income portion only

While you can withdraw money from your annuity at any time, there may be additional taxes, surrender fees, and other penalties that may be included in your contract. Surrender fees include:

  • A penalty of approximately 7% for withdrawing assets during the surrender period stated in your contract — typically 5-7 years; and
  • A penalty from the government for withdrawing assets before 59½ years old.  The penalty from:
    • A Qualified Annuity would be 10% of the total withdrawal amount; and
    • A Non-qualified Annuity would 10% of the withdrawal amount coming from interest and earnings.

Annuities are regulated by your state’s insurance commission and the federal Securities and Exchange Commission and the Financial Industry Regulatory Authority.

While your choices of annuities can seem quite complicated, it really comes down to choosing among multiple available options for funding, investing, withdrawing, and passing on your annuity.

There are seven major things that you consider when you are choosing annuities

Annuities can be funded as lump sums and/or discrete payments (premiums) over time. There is no limit the amount that can be invested in an annuity

The period over which you add funds to your annuity is known as the accumulation phase. Your choices will usually depend on your personal preferences and financial circumstances.

  • If you are purchasing an annuity well in advance of retirement you will usually be adding to the annuity over time.
  • If you receive a windfall, such as a large inheritance, lawsuit settlement, or lottery win, you can use it to either purchase an annuity or add to an existing one.
  • Another reason for lump sum additions may be that you are approaching retirement age and want to convert some of your assets or retirement funds into guaranteed income.
  • Funding an annuity through an individual retirement account (IRA) or another tax-advantaged retirement plan may entitle you to a tax deduction for your contribution.

Qualified Annuities

Qualified annuities are treated like tax-deferred (traditional) retirement plans. They may be purchased through an employer tax-deferred retirement plan or with money from a traditional IRA, 401(k) — Qualified Longevity Annuity Contract, or another account that is tax deferred.

Unlike non-qualified annuities, qualified annuities have caps on how much money may be invested in them. These caps are governed by your income and whether you participate in other qualified pension plans.

When funds from a qualified annuity purchased with pre-tax dollars from a traditional IRA or other retirement account are distributed to you, the entire amount is taxable because taxes have not yet been paid on that money.

Non-Qualified Annuities

Non-qualified annuities are treated like Roth retirement plans and are purchased with after-tax dollars.  When money from a non-qualified annuity is withdrawn there are no taxes due on income coming from the principal, since the money has already been taxed. Income taxes are levied only on income coming from the earnings, capital gains, and interest.

The IRS determines which portions of a non-qualified annuity withdrawal are taxable by using a calculation known as the exclusion ratio. This ratio is based on the length of the annuity, the principal and the earnings.

If a non-qualified annuity is set up to pay you for your entire life, the exclusion ratio will take your life expectancy into consideration. This can be found in the Internal Revenue Service (IRS) life expectancy table.

Exclusion Ratio = Sellers Cost Basis ÷ Expected Return (IRC §72[b])

  • Expected Return = Annual Payment × Life Expectancy
  • Annual Payment = Fair market value (FMV) of Property Transferred ÷ Present Value of Annuity Factor (1 – (1+r)-n/r:  r is the expected interest rate and n is the number of years left in life expectancy)

The idea is to spread the total of the principal and earnings of the annuity in regular payments over your lifetime. If you live beyond your calculated life expectancy you have received the entire principle of the annuity.

If your predicted life expectancy is 90 years old the exclusion ratio will calculate how much of each payment from your non-qualified annuity will be considered taxable earnings until then. After the age of 90 you have received all of your principal and all of the payout amount from the annuity is considered taxable income.

Transferring Annuity Funds

It may be possible to transfer your funds between annuities if you feel the need. There may be many reasons for this.

  • A new annuity can have a higher interest rate, lower fees, better investment options, or more features, such as an enhanced death benefit or guaranteed minimum income.
  • The annuity company may no longer be financially strong and you have a variable or indexed payment or are just concerned the company will fold and you will lose everything.

With non-qualified annuities (funded by after-tax dollars), you can transfer the funds between different kinds of annuities, such as fixed and variable, without facing an early-withdrawal penalty. These exchanges are guaranteed by Section 1035 of the Internal Revenue Code and are known as 1035 exchanges.

With qualified annuities (funded by pre-tax dollars), you can transfer the funds between different kinds of annuities, such as fixed and variable, but the transfers are limited to funds in the annuity that are considered tax-deferred. These are your contributions to an IRA or 401K, not the earnings.

Choosing how much risk you want to take with your money, when you have a choice, is an important part of determining what your money will be invested in. The level of risk is usually determined by individual preference and when you would like to begin getting income from your investment. In general, high risk investments are more judicious when it will be a long time before you will need the income from the investment. 

You may not have control over investment risks with many annuity companies, especially with fixed annuities, but some will give you limited choices in investments, either by:

  • Letting you or your financial advisor pick some of the investments; or
  • Determining the amount of risk you want to take, such as safe investments, aggressive investments, or some combination of risk.

When you begin getting payments it is called the annuitization phase. This can begin when you are over 59½ years old, although most people wait until they retire.

  • The choice  usually depends on your age, financial situation, and whether investments have been previously taxed.
  • You must begin to withdraw from qualified annuities (pre-tax dollars) by 70½ years old, while non-qualified annuities (after-tax dollars) have no upper limit.

If you withdraw funds before this, called the surrender period, you will be subject to surrender fees, unless you have a hardship rider.

  • The Internal Revenue Service will impose a 10% or more penalty for withdrawing funds before 59½ years old. 
  • The annuity provider will also impose a penalty, usually 7%, if money is withdrawn during a defined period of time, typically 5-7 years. Penalties may also be assessed after the surrender period if more than the contracted amount is withdrawn.
  • Surrender penalties typically decline annually over the surrender period.

Despite the surrender fees, you can consider this if you need cash for emergency situations, such as a terminal illness.

  • Most annuities allow you to withdraw 10% to 15% of the account for emergency purposes without penalty.
  • If you do not have a hardship rider, ask your annuity company if you can waive the penalty for amounts above this if you have a terminal illness. 
Immediate Withdrawal

If you begin receiving the income within a year of purchasing the annuity, it’s known as an immediate income annuity, also called a single premium immediate annuity. Typically, you would purchase immediate annuities with a single lump sum payment if you were approaching retirement. Your payments can either be a fixed amount or a variable one, depending on your choice and the contract.

You might choose this type of annuity as you get close to retirement if you:

  • Have a one-time windfall such as an inheritance or lawsuit settlement; and/or
  • Want to take a portion of your retirement savings and buy the annuity as a way to supplement your income from Social Security and other sources.
Deferred Withdrawal

If the payout or distribution phase begins a year or more later, the income annuity falls into the category of deferred income annuity (DIA).  Most DIAs are purchased well in advance of retirement, with the average length of deferment being 20 years.

  • DIAs are able to offer a guaranteed income during the annuitization phase by choosing low-risk investment options.
  • Since this results in a lower return on investment, many people choose investments with a higher yield before opening an annuity when they are approaching or at retirement age.

DIAs can be purchased three ways.

  1. A lump sum – single premium deferred annuities. 
    • The higher initial premium allows for a better long-term rate of return on investment.
    • This annuity can be a problem if you invested too much and either don’t have the money for other investments or will need to pay surrender fees if you need to remove money for emergency use.
  2. Multiple payments.
    • You can choose a scheduled premium deferred annuity and pay a specific amount on a regular schedule or a flexible premium deferred annuity where the premiums are adjustable
    • While the slower build-up of value by spreading the premiums over time ties up less capital, it reduces the long-term return on investment.
  3. A combination of the two.

The income payments from a DIA are typically higher than payments from an immediate annuity for two reasons.

  1. With a DIA, your principal has time to accumulate before you start taking payments. 
  2. If you have life annuities, you will get payments for the remainder of your life. The longer you wait to receive payments, you will get fewer payments over a shorter time, resulting in larger individual payments.

The choice of duration of your payments is probably the most important choice when it comes to annuities, but it is the most difficult to anticipate. You can choose to receive withdrawals until a certain total amount is reached, or spread payments out either over your lifetime or a more limited time frame.  Trying to make your annuity last until your death involves predicting your life expectancy, which is based on the IRS table and can vary depending on who is predicting it.

Life Option

A life option is the choice of getting payments from the annuity for the rest of your life.

  • If you live less than your life expectancy you will get back less than you put in and earned. Unless you account for this as described below, the company holding your annuity keeps the remainder of the account after your death.
  • If you live much longer than your life expectancy you will get back more than the full value of the annuity. Because you no longer have any basis in the annuity after your life expectancy:
    • Payments will now be considered gifts, requiring the annuity company to pay gift taxes on the payments; and
    • The money will increase your taxable estate. 

There may be three ways to reduce the odds of the company getting the rest of your annuity after your death. 

  1. You can create the annuity as a joint account with your spouse. 
  • After you die, they will continue to receive payments until their death.
  • The monthly payments will be lower with a joint account since two life expectancies are taken into account.
  1. You can opt for hybrid annuity which combines a life annuity with a period certain annuity.
  • This is called an Income for Life with a Guaranteed Period Certain Benefit annuity (also referred to as “life with period certain”).
  • In this case, the period certain phase refers to the specific time frame during which your beneficiary will get the remainder of payments if you die.
  1. Add a Death Benefit provision or rider to your annuity contract that names beneficiaries to receive the payments after you die.

Period Certain

The choice of a period certain or income for a guaranteed period annuity allows you to decide when and how long to receive payments. The duration of payments will determine the monthly payment amount.

  • Like the life option, the period certain option does not protect you from outliving your assets and has the risk of the company holding your annuity getting the remainder of your annuity if you die before the period ends.
  • The duration of payments may be based on how long you are predicted to live, personal preference, or a specific event, such as the full payment of a mortgage or when other retirement income becomes available.
    • A limited payout duration results in higher monthly payments compared to the life option.
    • When it is your personal preference, the typical choices are 10, 15, or 20 years.

Systematic Withdrawal Schedule

The systematic withdrawal schedule allows you to get payments from your annuity account in the amounts and with the payment frequency that you specify, until your account is emptied. As opposed to the period certain option, it is the payment choice that determines the duration of the payments.

Although there is a risk of the company getting the remainder of your assets if you die before the account is empty, unlike the period certain payment option you may be able to increase your payment amounts, especially if you have an emergency. This may allow you to empty the account before your death.

Lump Sum

If you have been building up your annuity for retirement, there is the option of getting the entire annuity as a lump sum payment.

  • You would get less money than if you received payment over time which would have included interest and capital gains. However, you could consider doing this if you think you can get a higher return on a different investment or develop a terminal illness and need the money.
  • You would pay income tax on the payment based on the nature of the annuity, qualified or non-qualified.
  • You would not have surrender fees if you did this after you are able to withdraw from the annuity, usually after the accumulation phase and reaching 59½ years old.

Once you have decided to start your withdrawals and how long you want to get payments the amount of each payment amount will be calculated. Your withdrawals can be fixed or change over time, as either variable or fixed-indexed.

 

Fixed Annuity

Indexed Annuity

Variable Annuity

Tax-deferred

Yes

Yes

Yes

Investment Choices

Limited

Preferred

Preferred

Guaranteed returns

Yes

Yes, but many be higher if the market does well

No, fluctuates with your portfolio

Fixed premiums

Yes

Yes

Yes

Typical Fees

1%-3%

6%-8% or more

4%-7% or more

The company’s actuaries calculate your fixed annual and taxable annual payment amount according to a complex formula that includes the duration of payment, payment amount choice (either as fixed or variable payments), the current dollar value of the account, your current age (the longer you wait before taking an income, the greater your monthly payments will be), the expected future inflation-adjusted returns from the account’s assets, and your life expectancy based on industry-standard life-expectancy tables.

Taxable Income Portion of Annuity Payment = Annual Payment – (Excludable Amount + Gain Amount)

Annual Payment = Fair market value (FMV) of Property Transferred ÷ Present Value of Annuity Factor (1 – (1+r)-n/r:  r is the expected interest rate and n is the number of years until expected lifetime date)

Gain Amount = FMV of Property – Property’s Basis [original cost of property]) ÷ Life Expectancy of Annuitant

Excludable Amount = Exclusion Ratio × Annual Payment

  • Exclusion Ratio = Sellers Cost Basis (difference between FMV and purchase price) ÷ Expected Return (IRC §72[b])
  • Expected Return of Annuity = Annual Payment × Life Expectancy

Spousal or other beneficiary provisions and riders are then factored into the equation. The more provisions and riders in the contract the more guarantees you have, the higher risk the insurance company will have, and the lower the annual payments.

This will be divided by the number of yearly payments. Most people choose to receive monthly payments, so the result would be divided by 12.

An indexed withdrawal amount may start with this calculation, but may need to be repeated when the investments do well and you are entitled to a higher payment.

The variable withdrawal amount is a more complex calculation since it varies with the success of the investments

Each has a different risk associated with it, so choose the one that you are comfortable with. 

Fixed Withdrawals

A fixed annuity payment is where you receive either a lump sum of money or the same amount for the remainder of the term of the annuity, whether you opt for the life option or period certain method. This fixed payment is based on the interest rate guaranteed at the time of purchase.

Fixed withdrawals provide a predictable source of retirement income during the terms of the policy.

  • You will receive that amount whether or not the company holding your annuity earns enough return on its own investments to support that amount. The risk is on the company, not you.
  • A drawback of a fixed payment is that if the investment markets do better than predicted, the company holding your annuity company, not you, will get the extra profits.
  • Although some annuities offer or allow you to add cost-of-living adjustments, most annuities do not keep pace with inflation and your payment loses spending power over time as the cost of living increases. This would be especially difficult in a period of serious inflation.

As insurance products, your state’s department of insurance has jurisdiction over fixed annuities. Advisors have a license to sell fixed annuities, so make sure yours does. You can find contact information for your state’s insurance department on the National Association of Insurance Commissioners website.

Indexed Withdrawals

Indexed annuity payments, also called equity-indexed or fixed-indexed annuities, are a form of fixed annuity but include the chance of a higher payment if the investment/stock markets indices, such as the S&P 500 do much better than predicted.

  • You are guaranteed a minimum payment, however the payment can be higher if the annuity does very well, although there is a maximum payment. Some annuities do this automatically, while others require you to file for the increase.
  • You are not at risk if the annuity does poorly, but the baseline amount may be lower.

Variable Withdrawals

A variable annuity is the riskiest choice for payments in that they will vary over time with the success of the annuity’s investments of your portfolio.

  • Investments can include mutual funds such as stocks, bonds and/or short-term money markets.
  • As the value of a variable annuity grows or shrinks over time, so does the payment. The money could even be reinvested rather than used for payments in a given year.
  • Some companies offer an array of living and death benefit riders that can guarantee a minimum income.

An additional fee charged for variable annuities is a mortality and expense risk charge that pays your issuer for the risk it assumes under the annuity contract, usually about 1.25% of your account value per year.

Required Minimum Distributions

Like traditional 401(k)s and IRAs, qualified annuities are tax-deferred investments which have a limit on how long you can defer withdrawals. The SECURE act sets this at 72 years old (70½ if you turned that age before 2020).

  • At that point you must begin taking required minimum distributions (RMDs).
  • RMDs are based on the value of your investments, age, and expected lifespan according to the  Internal Revenue Service (IRS) life expectancy table. 
    • RMDs are initially 4% of your annuity’s balance and increase with age.
    • This means that as you get older you must withdraw increasingly larger percentages of your account balance.
  • For each year you defer after that you will pay an excise tax penalty equal to 50% of the amount you should have withdrawn.

Selling Your Annuity

If you need money and withdrawal costs are too high you can sell all or a portion of your annuity. A company will buy the rights to your annuity payments for a lump sum. Although the lump sum amount would be higher than if you withdrew it, you will forfeit some or all of your future annuity payments.

Like any insurance policy, you can add any number of provisions and riders to annuities. There are provisions and riders that will protect you under a number of situations. They can be divided into living and death benefits.

Like any provision and rider, you need to consider the chance of needing the protection with the potential cost of:

  • Adding the provision or rider to your annuity;
  • Adding them to a different type of insurance; or
  • Taking out a separate policy.

Living benefits riders are any that apply to circumstances that may occur while you are alive and may include:

  • Increasing payments with inflation — Cost-of-Living Adjustment rider;
  • Setting a minimal benefit if you have a variable annuity that will protect you against any significant reductions in the payment amounts or value of the annuity due to market fluctuations;
  • Setting up specific payments, either a monetary amount until the principle is gone or a specific percentage of the principle for the first few years;
  • Paying additional benefits if you get a serious illness or need long-term care; and
  • Deferring surrender charges or accelerating payouts if you are diagnosed with a terminal illness or other qualifying life events such as becoming disabled, developing serious illness, or needing long-term care (hardship rider).

Death benefits riders are any that apply if you die before you have received all of your principal.

  • You can name beneficiaries or alternate annuitants.
  • They will receive any amount you specify from either the original premium or the remaining value of the annuity, whichever is higher, or from other death benefits.

If desired, you may use most types of annuities as an inheritance tool by naming beneficiaries for annuities if you die before the end of the annuity period.

  • In many cases this has already been accounted for by making it a joint and survivor annuity where the payments remain the same until your surviving spouse’s death. Since there is a chance that the annuity payments will continue for a longer time with a joint annuity, annual payments are generally smaller. 
  • Even if you have not, most of the time the surviving spouse will have benefit of survivorship.
  • Beneficiaries may be your children or other family members that cannot be part of a joint annuity.
  • Some types of annuities, typically immediate annuities, may not allow death benefits. For example, a single premium immediate annuity rarely allows you to name a beneficiary to inherit the annuity if you die before the specified duration of the annuity.

The payment method may be determined by the company holding your annuity or they may offer your beneficiaries distribution options similar to yours when you first opened the annuity.

  • A lump-sum payment of either the original premium or the remaining value of the annuity, whichever is higher. Options for the inheritance include:
    • Investing it as your beneficiary sees fit, although they will pay tax based on the nature of the annuity;
    • Transferring the money into an inherited IRA — eligible designated beneficiaries only, such as a surviving spouse, minor child or chronically ill person; or
    • Carrying out a 1035 exchange, which is a provision in the federal tax code allowing your beneficiary to trade in one annuity for another without tax implications
  • A stretch distribution payment option allows your beneficiary to take what is remaining in the annuity and make a non-qualified annuity and stretch the annuity payments out over the rest of their life.
    • Their life expectancy is used to calculate the minimum amount the beneficiary must withdraw each year.
    • They have the option of removing the remaining value at any point.
  • The five-year payment option gives your beneficiary up to five years to withdraw the rest of the annuity contract. This can be done with a combination of smaller incremental payments and one final, lump-sum payment at the end of the five years.
  • The spousal distribution payments makes your surviving spouse the new annuity owner. The payout amount and frequency are the same as they were when you established the annuity.
  • If beneficiaries opt for annuitized payments it must be done within 60 days.
    • Within the restrictions set by the company, beneficiaries can set the conditions to fit their preferences or needs.
    • Once the schedule is chosen, you can’t change it.

Capital gains from annuities are not stepped up like real estate, so the capital gains are calculated from the value at the time of purchase of the annuity, not the value at your death.

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