Fixed, Variable & Deferred Annuities

🔑 MASTER ANNUITY COMPARISON TABLE

⚠️⚠️ WHICH ANNUITIES ARE SECURITIES — guaranteed exam question

Variable annuities

Variable annuities are used to provide lifetime income in retirement. They allow unlimited contributions and can make payments that fluctuate until the annuitant dies.

• In that sense, an annuity can function like a self-made pension. You contribute money to the contract, and later you can choose to receive payments for life.
• Contributions (often called premium payments) can be made as periodic payments or as a lump sum.
• Variable annuities are generally non-qualified retirement plans*, so contributions are not tax-deductible (there’s no tax benefit just for contributing).
• 🔑 There are two general types of annuities — immediate and deferred — and the key difference is how long the accumulation phase lasts.

*You should assume variable annuities are generally non-qualified, but it’s possible to roll over qualified funds into an annuity. That creates a qualified annuity.

Immediate annuity

If someone reaches retirement with a large sum of money, they can start lifetime annuity payments quickly, without a long accumulation period. This is an immediate annuity: the insurance company begins retirement income soon after accepting the lump sum.

• If the lump sum is made in one payment, it may be called a single premium immediate annuity.

For example, an investor deposits $1 million into an immediate variable annuity and begins receiving monthly payments starting at $2,500. Those payments then fluctuate based on the investment performance of the separate account.

Immediate annuity benefits vs. risks

*The inaccessibility of the lump sum only becomes an issue if the investor needs more money than they’re receiving in their annuity payments.

⚠️ Worked example — dying early

**An annuity typically stops making payments once the account owner dies. Say an investor deposits $600,000 into an immediate annuity in return for average monthly payments starting at $1,800. If they die after one year, they will have received roughly $21,600 in total ($1,800 × 12 months). Exchanging $600,000 for $21,600 of payments is a severe loss, and it is one of the primary risks investors face with annuities.

Sidenote — Annuity bonuses

Some insurance companies offer annuity bonuses to encourage investors to purchase annuities. The company credits additional money when the customer initially funds the contract, typically as a percentage match.

Worked example

Say an insurance company offers a 6% annuity bonus on the initial premium. A customer pays a $150,000 premium, and the insurer credits an extra $9,000 ($150,000 × 6%). With the bonus, the investor’s starting annuity value is $159,000.

Deferred annuities

Deferred annuities are designed to grow assets over time before income begins.

Worked example

Say an investor contributes $1,500 per month to a deferred variable annuity starting at age 35. By age 60 they would have contributed $450,000 ($1,500 × 12 months × 25 years). Because contributions are invested, the account could grow beyond that amount, say to $900,000. In retirement the investor may annuitize the contract, which means giving up control of the $900,000 to the insurance company in exchange for monthly payments for life.

Deferred annuity benefits vs. risks

*Deferred annuities are not required to be annuitized.

The two phases

Regardless of annuity type, there are two general phases:

• Accumulation phase
• Distribution phase

Accumulation phase

🔑 Accumulation units

During the accumulation phase, contributions go into a separate account. It’s called “separate” because it’s kept separate from the insurance company’s own assets and capital. When a contribution goes into the separate account, the investor buys accumulation units. Like shares of stock, accumulation units measure the investor’s ownership interest and help track their basis (amount invested). As more money is contributed, more accumulation units are purchased.

⚠️ Accumulation units vs. annuity units

The separate account

• The investor controls the separate account and chooses how the money is invested.
• The contract typically offers a menu of diversified portfolios of stocks, bonds, and other products that are similar to mutual funds.
• The investor’s choices determine the level of risk and, therefore, the potential return.

Tax treatment during accumulation

Assets in the separate account grow tax-deferred, similar to other retirement plans. Dividends and capital gains aren’t taxed as they occur; taxes are generally owed only when distributions are taken (often in retirement). During the accumulation phase, income is reinvested in the contract.

🔑 Retirement-account rules

Variable annuities also follow several rules that apply to retirement accounts. Investors generally must wait until age 59 ½ to withdraw funds without penalty, and a 10% penalty may apply to early withdrawals.

Death benefit

Variable annuities typically provide a death benefit that applies only during the accumulation phase. It applies if the account owner dies before annuitizing the contract (electing lifetime payments).

Worked example

Say a 35-year-old contributes $400 per month and plans to continue until age 65. They die unexpectedly at age 55 after contributing $96,000 over 20 years ($400 per month × 12 months × 20 years). The death benefit guarantees a payment to the listed beneficiary: the greater of the owner’s basis or the current account value.

If the separate account performed poorly and the balance is $80,000 at death, the beneficiary receives $96,000 (the basis). The death benefit ensures that, if the owner dies before taking funds out, at least the amount contributed comes back.

If the investments performed well, the beneficiary receives the current account value. With the same $96,000 basis, say the account grew to $160,000. The beneficiary receives $160,000.

Sidenote — M&E charges

In the first example above, the account value at death was $80,000 while the basis was $96,000. The insurance company had to pay the $16,000 difference to the beneficiary. This cost is called mortality risk, which occurs when the account owner dies earlier than expected.

Insurance companies also face expense risk: the risk that operating costs rise (for example, due to unexpected claims, higher regulatory costs, or rising general business expenses).

To compensate for these risks, insurance companies typically assess M&E (mortality & expense) charges, which average around 1.25% annually.

🔑 Insurance company risks

🔑 M&E charge

Distribution phase

When the investor is ready to take money out, they enter the distribution phase. At that point, they can:

• Withdraw the entire separate account value as a lump sum
• Take random or systematic withdrawals (for example, $2,000 per month until the account is exhausted)

Taxation of distributions (non-qualified)

When distributions are taken from a non-qualified variable annuity, only the growth is taxable. Contributions (basis) were made with after-tax dollars, so they aren’t taxed again.

For example, if an investor contributed $50,000 and the account grew to $75,000, only the $25,000 of growth is taxable (as ordinary income).

⚠️ Non-annuitized withdrawals don’t guarantee lifetime income

If a lump sum or periodic withdrawal is taken from a deferred annuity*, the investor is not guaranteed income for life. If enough money is withdrawn, the separate account will eventually be depleted. Investors who want to avoid running out of funds generally avoid these payout options.

*We are not discussing this option with an immediate annuity because immediate annuities are almost always annuitized (payments for life). Otherwise, an investor with a large lump sum would often be better off placing those funds in a brokerage account, investing what they don’t need, and taking distributions as needed.

Annuitization

If the investor wants guaranteed income for life, they annuitize the contract. Annuitization means giving up ownership of the separate account in exchange for lifetime payments. When the investor annuitizes, accumulation units convert into a fixed number of annuity units. The value of those annuity units changes based on the performance of the separate account, which affects future payouts.

Sidenote — Taxes at distribution

In this section, we’ve learned the following about non-qualified variable annuities:

• Growth is taxable as ordinary income when withdrawn
• Two primary methods of withdrawal:
  • Not annuitizing and withdrawing funds when needed
  • Annuitizing and receiving periodic payments until death

🔑 LIFO (not annuitized) vs. exclusion ratio (annuitized)

Worked example — LIFO

If the account is not annuitized, Internal Revenue Service (IRS) rules require the growth to be distributed first. This is LIFO (last in, first out): after-tax contributions (basis) come out only after all growth has been distributed.

Say an investor contributes $40,000 and the account grows to $55,000 by the first withdrawal. They request a $18,000 distribution. How much is taxable?

The account holds $15,000 of taxable growth, and under LIFO that comes out first, along with $3,000 of basis. So $15,000 is taxable as ordinary income and $3,000 is a tax-free return of principal (basis).

Worked example — exclusion ratio

If the account is annuitized, IRS rules tax each payment on a pro-rata basis: each payment includes part tax-free basis and part taxable growth. This is often described as taxation under an exclusion ratio.

Say an investor receives $2,000 in the first variable annuity payout. It’s possible that $500 of it is taxable growth and the other $1,500 is a tax-free return of principal*.

*The exam is most likely to test the general idea, not the calculation of each portion.

• As with other retirement plans, variable annuities are subject to an early withdrawal penalty if a non-qualified distribution occurs prior to age 59 1/2.

Assumed interest rate (AIR)

• Annuity payments are typically made monthly. The first payout amount is set based on the annuitization structure. After the first payout, future payments depend on the performance of the separate account.

When an investor annuitizes, the insurer assigns an assumed interest rate (AIR). The AIR is a conservative estimate of the separate account’s projected growth.

🔑 AIR comparison (example: AIR = 3% annualized)

• 📌 This is why these annuities are considered “variable.”

🔑 PAYOUT (ANNUITIZATION) OPTIONS

There are three specific annuitization structures to know.

Straight life — worked examples

Say an investor chooses a straight life annuity when their separate account is worth $300,000. If they die one month later after receiving a single $1,500 payment, the insurance company profits by $298,500. The insurance company “wins.”

The reverse can happen. If the investor lives far longer than expected and collects $520,000 in total, that is a $220,000 gain over the $300,000 account value. The investor “wins.”

Life expectancy pricing

This highlights the role of life expectancy in pricing annuity payments. Insurance companies may require medical history and/or a medical exam. That information is reviewed by an actuary, who estimates life expectancy and helps the insurer set payout amounts.

Those estimates aren’t always correct. If the investor lives longer than expected, the insurer must continue payments for life. This is longevity risk - a risk to the insurance company, but a valuable guarantee to the investor. Pensions face this same risk.

Life with period certain — worked example

Investors who want to reduce the risk of “dying too soon” under a straight life annuity can choose life with period certain. Take a 10-year period certain paying $2,000 a month:

• Payments are guaranteed for life.
• If the investor dies within the first 10 years, payments continue to the beneficiary for the rest of the 10-year period.

Say the investor dies after 6 years of payments. The beneficiary receives the 4 remaining years, or 4 × 12 × $2,000 = $96,000.

Unit refund — worked example

An investor contributes $250,000, annuitizes the contract, and dies after receiving $160,000 in payments. The remaining $90,000 ($250,000 − $160,000) goes to the beneficiary, either as a lump sum or on a payment schedule, depending on the annuity’s structure.

Definitions

Sidenote — Qualified annuities

You should expect the exam to primarily focus on non-qualified variable annuities. It’s usually best to assume an annuity is non-qualified unless a question states otherwise. A non-qualified variable annuity allows unlimited non-deductible (after-tax) contributions and tax-deferred growth. At distribution, only the growth is taxable as ordinary income.

In some cases, you may see a question about a qualified annuity. A qualified annuity is funded with pre-tax money rolled over from another qualified plan.

Worked example

An investor puts $80,000 into a 401(k). At retirement the account has grown to $120,000, and they roll it into a variable annuity.

Every future withdrawal is taxable as ordinary income. Unlike a non-qualified annuity, where only growth is taxable, the entire amount withdrawn from a qualified annuity is taxable.

Suppose the investor takes the whole $120,000 as a lump sum. Ordinary income tax applies to all of it: the $80,000 basis plus $40,000 of growth.

⚠️ Qualified vs. non-qualified annuity

Fixed annuities

Now that you understand a variable annuity, we can briefly cover a fixed annuity. You shouldn’t expect many test questions on this product because it is not considered a security. That’s because the investor does not take on investment-related risk (for example, market risk).

With a fixed annuity, contributions go into the insurance company’s general account, not a separate account controlled by the investor. The insurance company invests the funds and guarantees a (typically low) rate of return (for example, 3%).

Fixed vs. variable — pros and cons

• ⚠️ Remember: any investment with a fixed rate of return is subject to inflation risk. If prices rise faster (in percentage terms) than the guaranteed rate of return, purchasing power falls.

Key points

Variable annuities

• Unlimited non-deductible contributions
• Contribution options:
  • Lump sum
  • Periodic contributions
• Offers tax-deferred growth
• Distributions taxable above basis

Immediate annuity

• Investor contributes a large lump sum
• Immediately annuitizes and receives payments

Deferred annuity

• Investor contributes over time
• Takes withdrawals or annuitizes later in retirement

Accumulation phase

• When contributions are made
• Death benefit applies

Death benefit

• Beneficiary keeps GREATER of:
  • Amount invested
  • Account value
• Applies if the account owner dies during the accumulation phase

Variable annuity insurance company risks

• Mortality risk
  • Investor dies earlier than expected, triggering the death benefit
• Expense risk
  • Business expenses rise
• Longevity risk
  • Investor lives longer than expected, forcing annuity payments to be paid longer

Separate account

• Where assets are held
• Customer in control of investing
• Investment choices:
  • Equity-based portfolios
    • Hedge against inflation
  • Debt-based portfolios
    • Subject to inflation risk

Distribution phase

• Investor receives income in retirement
• Non-annuitization options
  • Lump sum
  • Periodic payments
• Annuitization options:
  • Straight life annuity
  • Life with period certain
  • Joint and last survivor

Non-qualified annuity taxation

• Growth is taxable as ordinary income
• Withdrawals (non-annuitization)
  • Growth is distributed first (LIFO)
• Annuitization
  • Basis and growth distributed simultaneously
  • Taxed on a “pro-rata” basis (a.k.a. exclusion ratio)
• Not subject to RMDs

Qualified annuity taxation

• All distributions taxed (growth and basis) as ordinary income
• Subject to RMDs starting at age 73

Fixed annuities

• Like a variable annuity, but:
  • Not a security
  • General account instead of a separate account
  • More exposed to inflation risk

Sources

Primary/official references for the material on this page. Every link was fetched and returned HTTP 200 on 2026-08-15.