Annuities

An annuity is a contract between an individual and an insurance company where the insurer promises periodic payments in exchange for premium(s). The primary purpose is to provide a guaranteed income stream the annuitant cannot outlive (longevity risk protection).

Annuity Overview

• Two main phases:

• Tax-deferred growth - no taxes on earnings until withdrawn or distributed
• Contributions are unlimited (no IRS contribution caps, unlike IRAs/401(k)s)
• Annuities are primarily insurance products, but variable annuities are also securities

Qualified vs. Nonqualified Annuities

Unless a question specifies "qualified," assume the annuity is nonqualified (funded with after-tax dollars). This changes how distributions are taxed.

Fixed Annuities

Structure

• Contributions go into the insurer's general account (commingled with insurer's other assets)
• Insurance company guarantees a fixed rate of return and bears all investment risk
• Provides a guaranteed minimum interest rate
• Low risk, low return relative to variable annuities

Regulatory Status

• Fixed annuities are NOT securities because the insurer bears investment risk, not the investor
• No SEC registration required; no prospectus required
• Regulated by state insurance departments only

Key Risk

• Purchasing power (inflation) risk: Fixed payments lose real value over time due to inflation. This is the defining limitation of fixed annuities

Suitability

Risk-averse investors and retirees who prioritize certainty and predictability over growth. Clients who cannot tolerate market fluctuations.

Exam Tip: Gotchas

• Fixed annuities are NOT securities because the owner bears no investment risk. They are regulated solely by state insurance commissioners, NOT the SEC. This is one of the most tested distinctions in the insurance section.

Variable Annuities

Structure

• Investor contributions go into a separate account, segregated from the insurer's general assets
• Subaccounts function like mutual fund portfolios (stocks, bonds, money market)
• The contract owner bears all investment risk since account value fluctuates with subaccount performance
• Both the cash value and the periodic payout fluctuate based on separate account performance
• This makes variable annuities a security: registered with the SEC under the Securities Act of 1933
• The separate account is registered as an investment company under the Investment Company Act of 1940
• Sold by prospectus (must be delivered at or before the sale)
• Sellers must hold a securities license AND an insurance license

Separate account vs. general account:

Key Fees

Variable annuity fees are typically higher than mutual funds:

Settlement (Annuitization) Options

Selected at annuitization; once chosen, generally irrevocable.

• Life only pays the most per period because the insurer has no obligation after death
• Joint and survivor pays the least per period because the insurer covers two lifetimes

Exam Tip: Gotchas

• Life only provides the highest periodic payment, and joint and survivor provides the lowest. A common exam trap reverses these. Remember: the longer the insurer's potential payout obligation, the lower each individual payment.
• The word "variable" in any insurance product name means it is a security. Variable annuities, variable life, and variable universal life are ALL securities requiring SEC registration and a prospectus.

Tax Treatment

• Earnings grow tax-deferred (no annual tax on inside buildup)
• No IRS contribution limits, a key benefit for high earners who have maxed qualified accounts
• Distributions of earnings are taxed as ordinary income (not capital gains, even if underlying investments were stocks)
• 10% early withdrawal penalty on taxable amounts if distributed before age 59 1/2 (in addition to ordinary income tax)
• Penalty exceptions: death, disability, substantially equal periodic payments (SEPP/72(t))

Last In, First Out (LIFO) rule (nonqualified annuities, accumulation phase withdrawals):

• Withdrawals are treated as earnings first (last in, first out)
• Earnings come out first and are fully taxable as ordinary income
• Once all earnings are withdrawn, remaining withdrawals are tax-free return of premium
• Applies to withdrawals taken before annuitization

Exclusion ratio (nonqualified annuities, annuitization phase payments):

• Once annuitized, each payment is split between taxable earnings and tax-free return of premium
• Exclusion ratio = Investment in contract / Expected return
• The excluded (tax-free) portion of each payment = Payment x Exclusion ratio
• After the full investment is recovered, 100% of remaining payments are taxable

Exam Tip: Gotchas

• Variable annuity gains are always ordinary income at withdrawal. No capital gains treatment, even after holding equity subaccounts for decades.
• The LIFO rule and the exclusion ratio apply at different times. LIFO applies to withdrawals during the accumulation phase (before annuitization). The exclusion ratio applies to periodic payments during the annuitization phase.

1035 Exchanges

Internal Revenue Code (IRC) Section 1035 allows tax-free exchanges of certain insurance products. No gain or loss is recognized at the time of the exchange, and the cost basis of the old contract carries over to the new contract.

Permitted 1035 exchanges (must go "across or down," never "up"):

NOT permitted:

• Annuity to life insurance (cannot exchange "up")
• Must be the same owner on both contracts
• Must be a direct transfer between insurance companies (not a withdrawal and repurchase)

Important considerations:

• 1035 exchanges avoid income tax but do NOT waive surrender charges from the old contract
• The new contract may impose a new surrender charge schedule

Exam Tip: Gotchas

• A 1035 exchange is tax-free but does NOT eliminate surrender charges. Also, you can exchange a life insurance policy INTO an annuity, but you CANNOT exchange an annuity INTO a life insurance policy.

Suitability

Suitable when:

• Investor has already maxed all qualified retirement accounts
• Long time horizon (10+ years to benefit from deferral)
• Needs guaranteed lifetime income
• High tax bracket (benefits most from deferral)

NOT suitable for:

• Funding an IRA or 401(k): The annuity's tax deferral adds no additional benefit inside an already tax-deferred account. The investor only pays higher fees and surrender charges for nothing
• Investors in low tax brackets: Tax deferral benefit is minimal
• Elderly investors with short time horizons (surrender periods may outlive them)
• Investors needing short-term liquidity: Surrender charges make early exit costly
• FINRA Rule 2330 sets suitability standards for variable annuity recommendations including exchanges

Exam Tip: Gotchas

• Funding an IRA or 401(k) with a variable annuity is a classic unsuitable recommendation. The tax deferral is redundant (already tax-deferred), and the investor only adds fees and surrender charges.

Indexed (Equity-Indexed) Annuities

Structure

• Returns linked to a stock market index (e.g., S&P 500) but with a guaranteed minimum floor
• Combine features of fixed annuities (guaranteed floor) and variable annuities (market-linked upside)
• Premiums invested in the insurer's general account (not a separate account)
• Owner does not bear direct investment risk - the insurer guarantees a minimum return (typically 0-3%)

The Four Return-Limiting Mechanisms

• Multiple mechanisms may apply simultaneously (e.g., participation rate AND cap rate)

Regulatory Status

• NOT a security under current SEC guidance; regulated as an insurance product by state insurance departments
• Rationale: guaranteed floor means the owner does not bear investment risk
• Subject to surrender charges (often longer surrender periods than traditional fixed annuities, up to 10-15 years)
• Complex products with suitability concerns - suitable only for investors who understand the trade-offs

Suitability

Investors wanting some market participation with principal protection. Lower risk than variable annuities but more growth potential than fixed annuities.

Exam Tip: Gotchas

• Indexed annuities are NOT securities despite being linked to a market index. The guaranteed minimum floor means the investor does not bear investment risk. Do not confuse them with variable annuities, which ARE securities.