Payout Options and Penalties for Annuities
by Shane Flait ,©2008

Fixed deferred annuities are life insurance contracts that guarantee a specific (fixed) interests rate. They also guarantee a return of your principal. And, you get tax -deferred growth of your money until you withdraw it. The same is true for variable deferred annuities. Their yearly return comes from interest, dividends, or capital gains depending on the ‘fund’ you have your money invested in.

The tax deferred character of annuities makes them useful as a savings vehicle for your retirement. Since defined-benefit pensions are slowly disappearing, most workers now fund their retirement through tax-deferred savings programs. They can also use a tax-deferred annuity to create their own pension plan – and choose among several payout options.

During the accumulation phase of your annuity, you can choose to make a series of fixed contributions, or a lump sum and any other contributions. Unlike for qualified plans, there’s no yearly limit how much you can contribute to them. Unless the annuity is part of a qualified plan itself, your contributions are not tax-deductible and they needn’t come from working income.

The benefit of nontaxable contributions means that those contributions makeup the tax basis of your investment. It won’t be taxed when you withdraw money, only their earnings will be – since the latter grows tax-deferred.

Early withdrawals
In return for the deferred taxation on earnings, you’ll are penalized for withdrawals from you annuity before your 59½.  The IRS imposes a 10% penalty on any earlier withdrawal in addition to income taxes on your earnings.

There are a series of exceptions to the penalty for early withdrawals. Having a disability is one. You can also begin annuitization if your yearly payouts are substantially equal periodic payments over your live or in joint with your spouse.

Payout Options:
Withdrawing money starts the annuitization phase. Depending on the options offered by you insurance company, you can take your payouts either as a lump-sum payment, a systematic withdrawal schedule, or under an annuitization method. The lump-sum payment will no doubt push you into a higher tax bracket causing a lot of your earning to be taxed away.

Under a systematic withdrawal schedule, you can choose what your monthly payment will be, and how many payments you want to receive. But, of course, how much you’ll receive over how many months depends on how much you have in your account.

Options under the annuitization methods are:

• Life Option: this pays you a stream of fixed payments until you die.
• Joint-Life Option: this pays husband and wife until the last survivor dies.
• Period Certain: this pays a stream of income for your choice of a defined period of time – such as 10 or 20 years. If you elect it as ‘period certain’, say for 10 years, even if you die after 2 years, the contract will maintain the payments to your beneficiary for the remaining 8 years.
• Life with Guaranteed Term: this pays just as the Life Option, but guarantees it will pay for a guaranteed term of your choice - such as 10 years. So if you die in just 2 years, the payments will continue to your beneficiary or estate for the 8 years remaining.

Taxing Payout
The IRS considers that whatever you withdraw is made up both principal and earnings. The latter is taxed. The ratio of each payout that is a return of your basis (principal or contributions) is called the exclusion ratio. Ask you insurance company what the exclusion ratio (i.e. the fraction of your yearly withdrawal that’s not taxed) is for payments received that year. 

Shane Flait is a writer and educator. Get more info at www.EasyRetirementKnowHow.com