How Annuities Work: A Guide to Types, Taxes, and Income Distributions for Financial Advisors

Whether annuities are an area you already specialize in or one you are just getting started with, the growing conversation around their impact on client outcomes is hard to ignore. In this comprehensive guide, we will walk through how annuities work and several different types of annuities to help you understand how they can be applied in the real world.

What is an annuity?

At a high level, an annuity is a contract between an individual and an insurance company in which the individual contributes funds in exchange for guaranteed future payments and/or asset growth. In these contracts, the carrier absorbs a portion of the risk that the individual would otherwise carry in a true investment vehicle. Annuities can be purchased with cash or funded through an existing investment account.

Qualified vs. non-qualified: How are annuities taxed?

The first distinction between annuities is whether they are qualified or non-qualified. In other words, were pre-tax dollars or after-tax dollars used to fund the product? All annuities grow tax-deferred, but the tax treatment at distribution is where the distinction really matters for the client's financial plan.

What is a qualified annuity?

A qualified annuity is funded with pre-tax dollars, typically through a traditional IRA, 401(k), or similar retirement plan, meaning every dollar withdrawn from the annuity will be taxed as ordinary income. As with similar savings vehicles, qualified annuities can be subject to required minimum distributions (RMDs).

For qualified annuities with guaranteed income streams, distributions can usually satisfy RMDs. With changes rolled out from SECURE Act 2.0, any excess income beyond the RMDs owed from a lifetime income annuity can satisfy RMDs for similar account types eligible for aggregation, such as traditional IRAs.

What is a non-qualified annuity?

A non-qualified annuity is purchased with after-tax dollars, meaning only the earnings are taxed upon withdrawal, while the principal investment comes back tax-free. Non-qualified annuities are not subject to RMDs.

Types of annuities: Fixed, variable, indexed, and indexed variable

The next difference across annuities is how each grows. There are four main annuity product archetypes: Fixed, variable, indexed, and indexed variable. You’ve probably seen other annuities with different names, but each can be traced back to one of these four.

What is a fixed annuity?

A fixed annuity is the most traditional annuity type, set to earn a “fixed,” predetermined rate of return, referred to as the crediting rate. Fixed annuities were once a popular product but have become less attractive over time. Stagnant crediting rates, the emergence of other annuity types, and even today’s high-yield savings accounts offering higher return potential have all contributed to the shift.

What is a variable annuity?

A variable annuity offers the ability to tie returns to mutual funds or similar sub-accounts depending on the carrier. While this product has the potential for stronger performance, and therefore a higher return credited to the annuity, market losses can negatively impact the annuity's value. The traditional variable annuity was popular upon its introduction in the 1950s, but high fees and exposure to market losses have contributed to its declining popularity over time.

What is an indexed annuity (fixed indexed annuity/FIA)?

As the name suggests, the indexed annuity, or fixed indexed annuity (FIA), ties its returns to the performance of an index, typically a large-blend index. There are four key components to the indexed annuity's rate of return:

• Participation rate: The percentage of the index's return that the carrier will match
• Floor: The minimum rate of return the annuity can earn, providing protection even in down markets
• Cap: The maximum rate of return that can be credited to the annuity
• Spread: Often functioning as the carrier's administration fee and a way to offset their cost in providing the floor, this is the percentage deducted from the return before it is credited

What is an indexed variable annuity (registered index-linked annuity/RILA)?

Finally, we arrive at one of the most popular annuity types today: the indexed variable annuity. Known by many names, including registered index-linked annuities (RILAs), hybrid annuities, structured annuities, and buffer/buffered annuities, these products have recently gained significant traction in the industry.

RILA sales amounted to $1.9B in 2014. In the next decade, sales rose to $47.4B. This popularity surge went hand-in-hand with the sudden focus on creating secure investments and insurance products brought on by COVID-19. The reason is straightforward: RILAs combine the potential for higher market-linked returns while providing a buffer against market losses, hence the name buffer annuity. Where the variable annuity carries substantial downside risk, the indexed variable annuity introduces a buffer, or the percentage of loss the insurance company will absorb in a given year. If losses exceed the buffer percentage, the account value is reduced by the amount exceeding that threshold.

Similar to the fixed indexed annuity, the indexed variable annuity includes both a cap and a participation rate. The key differentiator, however, is the buffer itself. This added layer of protection, combined with the absence of the spread and certain fees found in fixed indexed annuities, has strengthened the appeal of RILAs across the industry.

It is important to note that there is still the potential for capital losses with this investment style vehicle, but the buffer can create a sense of apparent security for accounts that don’t hit past the buffer percentage.

Annuity income options: Annuitization vs. lifetime income riders vs. no income riders

The key question with any annuity is whether the client needs an income stream.

• No income needed (yet): Leave the funds untouched and let the annuity act as another type of accumulation vehicle. This can be a good fit for clients who have already maxed out their other savings options and/or are looking for a different type of savings vehicle. Withdrawals are still possible with this approach, but a guaranteed income stream is not, unless the carrier offers the uncommon option to turn one on later or the client pursues a 1035 exchange or annuity rollover.
• Income needed: Annuitization or lifetime income provides a steady cash flow to supplement retirement spending, whether that's covering essentials or funding more fun expenses.

Both guaranteed income stream options share a few nuances worth noting:

• Single vs. joint payouts: A single income stream ends when the insured passes away during the guaranteed period. A joint stream continues to the surviving spouse or partner. Typically, the single income stream has a higher payout vs. a joint income stream.
• Level vs. increasing payments: Most contracts offer a yearly guaranteed income increase or cost-of-living adjustment (COLA) to help payments keep pace with inflation and to cover any RMDs owed from qualified lifetime income annuities. For these reasons, the level payments are not as common, especially for qualified lifetime income annuities.

Annuity illustrations map out these projections over the life of the contract, making them an essential reference when planning. Illustrations lay out the income schedule, whether it is structured as a dollar amount, a percentage of the annuity's value, or both, and often showcase any benefit base step-ups for lifetime income annuities.

What is an annuity with annuitization?

Annuitization is exchanging the value of the annuity for a guaranteed income stream. Carriers may offer three structures:

• Lifetime: Income continues for the rest of the insured's life after starting.
• Period certain: Income is paid for a set number of years. Often referred to as a guaranteed period.
• Lifetime with period certain: Income lasts for the longer of the insured's lifetime or a specified period of time.

Each option for annuitized annuity distributions offers its own perks and drawbacks so it is important to thoroughly consider the ramifications and benefits of each option.

What is a lifetime income annuity?

Once distributions begin, lifetime income provides the insured with a guaranteed income stream for the remainder of their life. Often referred to as an income rider, the income stream can be calculated based on the benefit base, which may differ from the actual account value of the annuity. If the value of the annuity is depleted within the lifetime of payouts, the payments would still continue. Some carriers may have an adjustment at that time, but that is not usual practice as these calculations are usually run in consideration of the client’s expected lifespan and the cost/benefit analysis of continued payments.

The benefit base will generally increase by a fixed roll-up rate or step up to the client's account value, whichever is greater. While the guaranteed income stream is appealing, it does come with tradeoffs. Two of those tradeoffs serve as fees that reduce the annuity’s returns, calculated as an account value (AV) based fee and a benefit base fee.

What is a surrender period?

A surrender period is the window of time during which the insured will incur a fee for withdrawing funds from the annuity. The length and structure of that fee vary by carrier. Some products and carriers offer little to no surrender fee, while others use a tiered structure that decreases each year after the annuity is purchased. It is not unusual to see surrender periods ranging from three to ten years.

Many carriers also build in exceptions, such as disability, job loss, or other qualifying life events. Some carriers even waive the fee if the withdrawal stays under 10% of the annuity’s value and is made within the surrender period. The surrender fee is worth considering when weighing withdrawal options if an immediate need arises, which is likely the intention behind it. It works in the carrier's favor by ensuring they get some level of money to cover costs of opening up and maintaining the product, while also aiming to benefit the insured by encouraging them to leave the funds untouched long enough for the annuity's value to actually grow. Most annuities are intended to be long-term investments and are typically built to not be an immediate liquid asset.

Aligning client needs with annuities

As we have covered, there are many different types and functions of annuities, which makes them a versatile tool for a wide range of client situations. The real question is not whether to use an annuity, but whether the client has a specific need that an annuity is best positioned to address. Annuities are not a blanket solution for every client.

One place to start could be with clients who have enough assets on hand to purchase an annuity without jeopardizing their financial well-being, then aligning the annuity type and distribution strategy with their goals, risk tolerance, and retirement timeline. Here are two generic sample clients where annuities could be a strong tool to evaluate:

• The risk-conscious pre-retiree: This client is 10 to 15 years from retirement and has built up meaningful savings but is growing uncomfortable with the full market exposure of their traditional IRA. Leveraging the balance in the IRA to purchase a fixed indexed annuity or indexed variable annuity set up as a deferred annuity (also referred to as “regular withdrawals”) can offer growth potential and the option for sporadic distributions later. This shift could help alleviate some of the direct market risk from the traditional IRA.
• The income stability anxious pre-retiree: This client is close to their retirement, worried about the reliability of Social Security, and anxious about having a dependable income stream to cover their retirement living expenses without worrying about market losses. A traditional fixed annuity or a buffer annuity with a lifetime income rider or annuitization option can create a predictable, pension-like cash flow that helps alleviate clients’ anxiety.

In each case, the annuity is not replacing the broader financial plan. Instead, it is filling a specific gap within it. That distinction is what separates a well-placed annuity recommendation from a generic product pitch.

Build and compare annuity proposals in RightCapital

As with any strategy, it is important to evaluate it on a case-by-case basis within the client plan as each client’s needs are unique. Ready to turn these concepts into client conversations? Learn more about implementing and discussing annuities.

Log into your RightCapital account to start building annuity proposals, modeling existing annuities, and comparing income rider options side-by-side in real time. New to RightCapital? Schedule a demo and try it for yourself with a 14-day free trial.