Annuity classification and payout options

What an annuity is

An annuity is an insurance contract that does the opposite of life insurance: instead of creating a sum of money when the owner dies too soon, it converts a sum of money into a stream of income the owner cannot outlive. Federal tax law describes the same thing from the payment side -- an "amount received as an annuity" under an annuity, endowment, or life insurance contract, payable for a period certain or during one or more lives.

Every annuity has two phases. During accumulation, money goes in and interest is credited. During annuitization (the payout phase), the accumulated value is converted into periodic income. The annuity starting date -- the first day of the first period for which an amount is received as an annuity -- is the line between them.

Classifying annuities

Exam questions almost always classify an annuity along one of four independent axes. The same contract gets a label on each axis, so a product can be a "flexible premium deferred indexed annuity" without contradiction.

• How premiums are paid -- single premium (one lump sum) or periodic premium

(level or flexible, paid over time).

• When income begins -- immediate (payout starts within about one payment period,

necessarily funded by a single premium) or deferred (payout starts at a chosen later date, allowing an accumulation period).

• How interest is credited -- fixed (the insurer guarantees a minimum rate and bears

the investment risk), indexed (credited by formula tied to an external index, with a floor), or variable (the owner picks subaccounts and bears the market risk; Florida regulates fixed-dollar and variable annuity contracts side by side).

• Number of lives covered -- a single life annuity or a joint / joint and survivor

annuity measured on more than one life.

Know the parties, too: the owner buys the contract and holds the rights, the annuitant is the measuring life whose age and life expectancy set the payment, and the beneficiary receives whatever is payable at death. They are often, but need not be, the same person.

Payout options

At annuitization the owner elects a settlement option. Every option trades income per dollar against protection of the remaining principal -- the more the insurer promises to pay regardless of survival, the smaller each payment.

• Straight life (life only) -- income for the annuitant's lifetime, nothing after death.

The largest payment of any lifetime option, and the one that risks losing the unpaid balance to an early death.

• Life with period certain -- lifetime income, but if the annuitant dies inside the

guaranteed period (10 or 20 years, say) payments continue to the beneficiary for the rest of it. Tax law treats this as a life annuity with a minimum period of payments certain.

• Life with refund (cash or installment) -- lifetime income with a guarantee that total

payments will at least return the consideration paid; any shortfall goes to the beneficiary as a lump sum or in installments.

• Joint and survivor -- income while either annuitant lives, often stepping down (joint

and two-thirds, joint and one-half) when the first dies. Two lives means a longer expected payout, so payments start lower.

• Period certain only / fixed period -- a set number of years, with no lifetime

guarantee at all.

• Fixed amount -- a chosen payment amount continues until the account is exhausted.

How payout income is taxed

Gross income includes amounts received as an annuity, but only the gain portion. The exclusion ratio divides the investment in the contract as of the annuity starting date by the expected return under the contract as of that date; that fraction of each payment is a tax-free return of the owner's own money and the rest is taxable interest. Where expected return depends on a life expectancy, it is computed from actuarial tables; otherwise it is simply the total of the amounts receivable.

Two limits complete the picture. Once the whole investment in the contract has been recovered, the exclusion stops -- later payments are fully taxable. And if payments cease at the annuitant's death with investment still unrecovered, the unrecovered amount is allowed as a deduction on the annuitant's last return. Qualified employer plan annuities use a simplified method instead of the exclusion ratio, dividing the investment by a table-driven number of anticipated payments keyed to the annuitant's age (or the annuitants' combined ages).