Personal uses of annuities: tax deferral, retirement income, education funds, and guaranteed minimum withdrawal benefits

Four reasons people buy an annuity

An annuity is the only financial product that can turn a sum of money into an income the owner cannot outlive. Individuals buy annuities for four main personal purposes, and the exam expects you to match each need to the right contract feature:

1. Tax deferral while money grows
2. Retirement income, including lifetime income
3. Education funds for a child or grandchild
4. Guaranteed minimum withdrawal benefits, which protect income from market losses

Tax deferral

Interest and investment earnings inside a deferred annuity are not taxed as they are credited. Tax is deferred until money comes out. Because the dollars that would have gone to tax each year stay in the contract, the account compounds faster than a comparable taxable account.

• A non-qualified annuity is bought with after-tax dollars. The premiums are the owner's cost basis and come back tax-free. There is no federal limit on how much can be put in.
• A qualified annuity funds an IRA or employer plan. Contributions are usually pre-tax, so every dollar paid out is taxable, contribution limits apply, and required minimum distributions begin at age 73 for owners born from 1951 through 1959, and at age 75 for owners born in 1960 or later.
• Withdrawals from a non-qualified deferred annuity are taxed earnings first. Gain comes out first and is taxed as ordinary income, never as capital gain.
• Annuitized payments use an exclusion ratio. Part of each payment is a tax-free return of basis, and the rest is taxable interest.
• Taxable money taken before age 59 and a half generally carries an extra 10 percent federal tax penalty. Exceptions include death, disability and a series of substantially equal periodic payments for life.
• Deferral belongs to natural persons. If a corporation owns a deferred annuity, the yearly gain is taxed to the owner as ordinary income each year. A trust holding the contract as agent for a natural person keeps the deferral.

Retirement income

The classic use is to accumulate during working years and then annuitize, converting the account into income. A life income option shifts longevity risk, the risk of outliving savings, to the insurer. Owners who want flexibility can take systematic withdrawals instead, which keeps the account accessible but can be depleted. A longevity annuity bought at retirement can start payments late in life, such as at age 85. Inside a retirement account, a Qualified Longevity Annuity Contract (QLAC) can defer required distributions on that money to age 85.

Education funds

A deferred annuity can build a college fund, because earnings grow tax-deferred and premiums can be flexible. Its weaknesses for this purpose are tested often:

• A non-qualified annuity has no education exception to the 10 percent penalty. If the owner is under 59 and a half when tuition is due, taxable withdrawals are generally penalised.
• Surrender charges may apply in the early contract years.
• The earnings withdrawn are taxed as ordinary income.

The fit is best when the owner, often a parent or grandparent, will be 59 and a half or older when the child starts school. By contrast, distributions from an IRA, including an IRA annuity, that pay qualified higher education expenses for the owner, a spouse, a child or a grandchild are exempt from the 10 percent penalty, though still taxable.

Guaranteed minimum withdrawal benefits

A guaranteed minimum withdrawal benefit (GMWB) is a living benefit rider, sold mainly on variable annuities. Normally the owner of a variable annuity bears all the investment risk. The rider guarantees the owner may withdraw a set percentage of a benefit base, typically the premiums paid, each year until the whole base has been recovered, even if poor markets drive the account value to zero. A lifetime version, often called a guaranteed lifetime withdrawal benefit, keeps payments going for life.

• The owner does not annuitize, so the account stays accessible and keeps any market gains.
• Withdrawing more than the allowed amount reduces the guarantee.
• The rider has an extra annual charge and usually limits investment choices.

Other living benefits guarantee a minimum account value (GMAB) or a minimum annuitization base (GMIB). A guaranteed minimum death benefit protects the beneficiary, not the living owner.