C.22 Annuities Overview

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1 A. Professional Conduct and Regulation

A.1 Code of Ethics and Standards of Conduct A.1.1 The Six Ethical Principles A.2 Procedural Rules and Discipline A.2.1 Fitness Standards for Candidates A.3 Financial Institutions Overview A.3.1 Broker-Dealers vs. RIAs A.4 SEC and Securities Regulation A.4.1 FINRA and Broker-Dealer Regulation A.4.2 State Securities Regulation A.5 Consumer Protection Laws A.5.1 Privacy and Confidentiality Requirements A.6 Fiduciary Duty and Application

2 B. General Principles of Financial Planning

B.7 The Financial Planning Process B.7.1 Establishing the Client Relationship B.7.2 Gathering Client Data and Goals B.8 Personal Financial Statements B.8.1 Key Financial Ratios B.9 Cash Flow Management B.9.1 Emergency Fund Planning B.10 Debt Management Strategies B.10.1 Mortgage and Home Financing B.11 Economic Concepts B.11.1 Planning for Inflation B.12 Time Value of Money Concepts B.12.1 TVM Calculations and Applications B.12.2 Loan Amortization B.13 Education Needs Analysis B.14 Education Savings Vehicles B.14.1 529 Plans In-Depth B.15 Education Funding Strategies B.16 Gift/Income Tax Strategies

3 C. Risk Management and Insurance Planning

C.17 Principles of Risk and Insurance C.17.1 Risk Management Process C.18 Analysis of Risk Exposures C.19 Health Insurance Fundamentals C.19.1 Types of Health Insurance Plans C.20 Disability Income Insurance C.20.1 Disability Policy Features C.21 Long-Term Care Insurance C.22 Annuities Overview C.22.1 Fixed vs. Variable Annuities C.23 Life Insurance Fundamentals C.23.1 Types of Life Insurance C.24 Business Owner Insurance Solutions C.25 Insurance Needs Analysis C.26 Insurance Policy and Company Selection

4 D. Investment Planning

D.27 Equity Securities D.27.1 Fixed Income Securities D.27.2 Mutual Funds and ETFs D.27.3 Taxation of Investment Vehicles D.28 Systematic Risk D.28.1 Unsystematic Risk D.29 Economic and Market Cycles D.30 Measures of Risk and Return D.30.1 Investment Performance Measures D.31 Asset Allocation Strategies D.31.1 Portfolio Diversification D.32 Bond and Stock Valuation D.32.1 Stock Valuation Models D.33 Investment Policy Statement D.33.1 Modern Portfolio Theory D.34 Active vs. Passive Investing D.34.1 Common Investment Strategies D.35 Alternative Investments D.35.1 Options and Derivatives

5 E. Tax Planning

E.36 Income Tax Fundamentals E.36.1 Filing Status and Tax Brackets E.37 Types of Income E.37.1 Deductions and Credits E.37.2 Capital Gains and Losses E.38 Business Entity Taxation E.38.1 Self-Employment Tax E.39 Taxation of Trusts and Estates E.40 Tax Reduction Strategies E.40.1 Retirement Account Tax Strategies E.41 Property Transactions E.41.1 Basis Rules for Acquired Property E.42 AMT and NIIT E.42.1 Special Tax Situations E.43 Charitable Giving Strategies

6 F. Retirement Savings and Income Planning

F.44 Retirement Needs Analysis F.44.1 Sources of Retirement Income F.45 Social Security Benefits F.45.1 Social Security Claiming Strategies F.45.2 Medicare Planning F.46 Eldercare and Special Needs Planning F.47 Qualified Plan Overview F.47.1 Defined Benefit Pension Plans F.47.2 Defined Contribution Plans F.48 Eligibility and Vesting F.48.1 Coverage and Discrimination Testing F.48.2 Contribution and Benefit Limits F.48.3 401(k) Plan Features F.49 Non-Qualified Deferred Compensation F.49.1 Executive Compensation Plans F.50 Retirement Plan Selection for Businesses F.50.1 Individual Retirement Accounts F.51 Distribution Rules F.51.1 Required Minimum Distributions F.52 Retirement Income Strategies F.52.1 Tax-Efficient Withdrawal Strategies F.53 Business Succession Planning

7 G. Estate Planning

G.54 Property Titling and Beneficiary Designations G.54.1 Beneficiary Designations G.55 Strategies to Transfer Property G.55.1 Lifetime Gifting Strategies G.56 Wills and Estate Documents G.56.1 Powers of Attorney G.56.2 Advance Directives and Healthcare Documents G.57 Federal Gift Tax G.57.1 Federal Estate Tax G.57.2 Generation-Skipping Transfer Tax G.58 Sources for Estate Liquidity G.58.1 Life Insurance for Estate Liquidity G.59 Trust Fundamentals G.59.1 Revocable Living Trusts G.59.2 Irrevocable Trusts G.59.3 Trust Income Taxation G.60 Marital Deduction Planning G.60.1 QTIP Trusts G.60.2 Portability of Estate Tax Exemption G.61 Intra-family and Business Transfer Techniques G.61.1 Family Limited Partnerships G.61.2 GRATs and IDGTs G.62 Postmortem Estate Planning Techniques G.62.1 Disclaimer Planning G.62.2 Estate Tax Elections G.63 Planning for Divorce and Unmarried Couples G.63.1 Estate Planning for Unmarried Couples G.63.2 Planning for Blended Families G.64 Planning for Special Needs and Circumstances G.64.1 Special Needs Trusts G.64.2 ABLE Accounts

8 H. Psychology of Financial Planning

H.65 Client and Planner Attitudes, Values, Biases H.65.1 Money Scripts and Money Attitudes H.65.2 Planner Self-Awareness H.66 Behavioral Finance H.66.1 Cognitive Biases H.66.2 Emotional Biases H.66.3 Heuristics and Mental Accounting H.67 Sources of Money Conflict H.67.1 Couples and Money Conflict H.67.2 Family and Intergenerational Money Conflict H.68 Principles of Counseling H.68.1 Therapeutic Techniques in Financial Planning H.68.2 Professional Boundaries and Referrals H.69 General Principles of Effective Communication H.69.1 Listening and Questioning Skills H.69.2 Managing Difficult Conversations H.69.3 Non-Verbal Communication H.70 Crisis Events with Severe Consequences H.70.1 Death and Divorce H.70.2 Job Loss and Health Crisis H.70.3 Sudden Wealth and Sudden Loss H.70.4 Natural Disasters and Traumatic Events

C.22 Annuities Overview

Key Takeaways Explain This Topic AI

Annuities are contracts with insurance companies that provide guaranteed income streams for retirement

Deferred annuities have two phases: accumulation (growth) and annuitization (payout)

Immediate annuities begin payments within one year of purchase with no accumulation phase

Annuity earnings grow tax-deferred until withdrawal, similar to qualified retirement accounts

Withdrawals before age 59 1/2 may incur a 10% early withdrawal penalty on the taxable portion

The exclusion ratio determines what portion of each annuity payment is tax-free return of principal
Last updated: October 2026

Annuities Overview

Annuities are contracts between an individual and an insurance company designed to provide guaranteed income, typically for retirement. They address a fundamental retirement planning concern: the risk of outliving one's assets. This section covers the basic structure, phases, timing options, and taxation of annuities—concepts frequently tested on the CFP exam.

What Is an Annuity?

An annuity is a contract in which an individual pays premiums (either as a lump sum or periodic payments) to an insurance company in exchange for a future income stream. The insurance company pools these payments with those of other annuity holders and uses actuarial principles to guarantee payments for a specified period or for life.

Key Characteristics
Contract with an insurance company : Unlike mutual funds or stocks, annuities are insurance products

Guaranteed payments : The insurer assumes the risk of providing payments regardless of market conditions or longevity

Tax-deferred growth : Earnings accumulate without current taxation
Designed for retirement : Primary purpose is providing income during retirement years
Protection against longevity risk : Payments can continue for life, regardless of how long the annuitant lives
When Annuities Make Sense

Annuities are appropriate when clients:

Have maximized contributions to qualified retirement plans (401(k), IRA)
Desire guaranteed lifetime income
Are concerned about outliving their assets
Want tax-deferred growth beyond qualified plan limits
Do not need liquidity or immediate access to funds

Annuities are generally not appropriate when clients:

Need access to funds before retirement
Want to leave significant assets to heirs
Seek maximum growth potential with market exposure
Have not yet maximized tax-advantaged retirement accounts
The Two Phases of Deferred Annuities

Deferred annuities have two distinct phases. Understanding these phases is critical for the CFP exam.

Accumulation Phase

The accumulation phase is the period when premiums are paid and the annuity grows in value. During this phase:

The owner makes premium payments (single premium or periodic)
Earnings grow tax-deferred
The account has a cash surrender value
Withdrawals may trigger surrender charges and early withdrawal penalties
No income payments are being received

The accumulation phase can last for years or even decades, depending on when the owner decides to begin receiving income.

Annuitization Phase (Payout Phase)

The annuitization phase begins when the owner converts the accumulated value into a stream of income payments. Key characteristics include:

Periodic payments begin and continue for a specified period or lifetime
The exclusion ratio determines the taxable portion of each payment
Once annuitized, the decision is typically irrevocable
Cash surrender value usually no longer exists
Payments are guaranteed by the insurance company

Feature Accumulation Phase Annuitization Phase
Premium payments Owner pays premiums No additional premiums
Income payments None received Regular payments received
Cash value Exists and grows Typically no cash value
Flexibility Can add funds, make withdrawals Generally irrevocable
Primary goal Asset accumulation Income distribution
Taxation Tax-deferred growth Exclusion ratio applies
Exam Tip: Accumulation Units vs. Annuity Units

For variable annuities specifically, the CFP exam may test the distinction between accumulation units and annuity units. During the accumulation phase, the owner holds accumulation units (similar to mutual fund shares). At annuitization, these convert to annuity units , which determine the payment amount. The number of annuity units remains fixed, but their value fluctuates with the underlying investments.

Immediate vs. Deferred Annuities

Annuities are classified by when income payments begin.

Immediate Annuities

An immediate annuity begins making payments within one year of purchase—typically within the first month. Characteristics include:

Purchased with a single lump-sum premium
No accumulation phase
First payment usually within 30 days
Useful for retirees who need income immediately
Often used to convert retirement account balances to guaranteed income
Also called single premium immediate annuities (SPIAs)

Example : A 65-year-old retiree uses $200,000 from a 401(k) rollover to purchase an immediate annuity. Payments of $1,100 per month begin the following month and continue for life.

Deferred Annuities

A deferred annuity delays income payments to a future date, allowing the account to grow during the accumulation phase. Characteristics include:

Can be purchased with a single premium or periodic payments
Accumulation phase allows tax-deferred growth
Annuitization can be triggered at the owner's discretion
Useful for individuals still in their working years
More flexible than immediate annuities

Feature Immediate Annuity Deferred Annuity
Premium payment Single lump sum Lump sum or periodic
Accumulation phase None Yes
Payment start Within 1 year (usually 1 month) Future date chosen by owner
Primary use Immediate retirement income Long-term retirement planning
Flexibility Limited More flexible
Deferred Annuity Payment Options
Single Premium Deferred Annuity (SPDA) : Funded with one lump-sum payment
Flexible Premium Deferred Annuity (FPDA) : Allows multiple premium payments over time
Qualified Longevity Annuity Contracts (QLACs)

A Qualified Longevity Annuity Contract (QLAC) is a special type of deferred annuity purchased within a qualified retirement account (IRA, 401(k), 403(b)) that can delay RMDs until as late as age 85.

Key QLAC rules (2026):

Maximum purchase : $210,000 (SECURE 2.0 repealed the former 25%-of-balance limit; Notice 2025-67 keeps $210,000 for 2026)

RMD exclusion : QLAC value is excluded from RMD calculations until payments begin
Latest start date : Payments must begin by age 85
No cash surrender value : Cannot be surrendered for lump sum
Death benefits : May include return of premium feature

Planning insight: QLACs are particularly valuable for clients who don't need all their retirement income early, want to reduce current RMDs, or are concerned about longevity risk beyond age 85.

Annuity Taxation

Understanding annuity taxation is essential for CFP candidates. The tax treatment varies based on whether the annuity is qualified or non-qualified.

Qualified vs. Non-Qualified Annuities

Qualified annuities are funded with pre-tax dollars within a retirement plan (IRA, 401(k)). The entire withdrawal amount is taxable as ordinary income because no taxes have been paid on contributions or earnings.

Non-qualified annuities are funded with after-tax dollars. Only the earnings portion is taxable; the original premium (basis) is returned tax-free.

Type Funding Taxation of Withdrawals
Qualified Pre-tax dollars Entire amount taxed as ordinary income
Non-qualified After-tax dollars Only earnings taxed; basis returned tax-free
Tax-Deferred Growth

Both qualified and non-qualified annuities benefit from tax-deferred growth . Earnings are not taxed until withdrawn, allowing the full amount to compound over time. This provides a significant advantage over taxable investments for long-term accumulation.

The Exclusion Ratio

For non-qualified annuities receiving periodic payments, the exclusion ratio determines what portion of each payment is tax-free (return of principal) versus taxable (earnings).

Exclusion Ratio Formula:

Exclusion Ratio = Investment in Contract / Expected Return

Where:

Investment in Contract = Total premiums paid (basis)
Expected Return = Annual Payment x Life Expectancy (from IRS tables)

Example : Sarah, age 65, annuitizes a non-qualified annuity with a $100,000 investment. Her annual payment is $8,000, and her life expectancy is 20 years.

Expected Return = $8,000 x 20 = $160,000
Exclusion Ratio = $100,000 / $160,000 = 62.5%

Each year, 62.5% of her $8,000 payment ($5,000) is tax-free return of principal, and 37.5% ($3,000) is taxable as ordinary income.

Important : If the annuitant outlives the life expectancy used in the calculation, all subsequent payments become fully taxable. The exclusion ratio applies only until the investment is fully recovered.

The 10% Early Withdrawal Penalty

Withdrawals from annuities before age 59 1/2 are subject to a 10% early withdrawal penalty on the taxable portion, in addition to ordinary income tax. This penalty is similar to early distributions from IRAs and 401(k)s.

Penalty calculation for non-qualified annuities :

The 10% penalty applies only to the earnings portion (taxable amount)
The return of basis is not subject to the penalty

Penalty calculation for qualified annuities :

The entire withdrawal is subject to the 10% penalty (since no taxes were paid on contributions)
Exceptions to the 10% Penalty

The penalty may be waived in certain circumstances:

Exception Description
Death Distributions to beneficiaries after owner's death
Disability Owner is disabled as defined by IRS

Substantially Equal Periodic Payments (SEPP) Series of substantially equal payments based on life expectancy (Section 72(t))

Immediate annuity Payments from an immediate annuity contract
LIFO Rule for Withdrawals

For non-qualified annuities, withdrawals during the accumulation phase are taxed on a Last-In, First-Out (LIFO) basis. This means earnings are considered withdrawn first and are fully taxable before any return of principal.

Example : A non-qualified annuity has $100,000 in premiums paid and $30,000 in earnings (total value $130,000). If the owner withdraws $20,000, the entire amount is taxable as ordinary income because it comes from the earnings portion first.

Exam Tip: LIFO vs. Exclusion Ratio

Remember: LIFO applies to withdrawals during the accumulation phase . The exclusion ratio applies to annuity payments during the payout phase . This distinction is commonly tested on the CFP exam.

Annuity Payout Options

When an annuity is annuitized, the owner selects a payout option that determines how payments are calculated and how long they continue.

Life Only (Straight Life)

Payments continue for the annuitant's lifetime only. Payments cease at death, even if the annuitant dies shortly after annuitization.

Advantage : Highest monthly payment
Disadvantage : No payments to beneficiaries after death
Best for : Healthy individuals with no need to leave assets to heirs
Life with Period Certain

Payments continue for the annuitant's lifetime, with a guaranteed minimum period (e.g., 10 or 20 years). If the annuitant dies before the period ends, payments continue to beneficiaries.

Advantage : Guarantees a minimum payout regardless of when death occurs
Disadvantage : Lower monthly payment than life only
Best for : Those concerned about dying shortly after annuitization
Joint and Survivor

Payments continue for two lives (typically spouses). After the first death, payments continue to the survivor, often at a reduced rate (e.g., 50%, 75%, or 100% of the original payment).

Advantage : Provides income for surviving spouse
Disadvantage : Lower initial payment than single life options
Best for : Married couples dependent on annuity income
Refund Annuity

Guarantees that at least the total premium paid will be returned. If the annuitant dies before receiving payments equal to the premium, the difference is paid to beneficiaries.

Installment refund : Beneficiary receives remaining balance in installments
Cash refund : Beneficiary receives remaining balance as lump sum

Payout Option Payments Continue Best For
Life Only Until death Maximum income, no heirs
Life with Period Certain Lifetime or guaranteed period Balance of income and legacy
Joint and Survivor Until both deaths Married couples
Refund Annuity Until premium recovered or death Recovering full investment
Key Concepts Summary

Concept Definition CFP Exam Focus
Accumulation Phase Period of premium payments and growth Distinguish from annuitization
Annuitization Phase Period of income payments Irrevocable, exclusion ratio applies
Immediate Annuity Payments begin within 1 year No accumulation phase
Deferred Annuity Payments begin at future date Has accumulation phase
Exclusion Ratio Portion of payment that is tax-free Investment / Expected Return
10% Penalty Additional tax for withdrawals before 59 1/2 Exceptions: death, disability, SEPP
LIFO Rule Earnings withdrawn first Applies to accumulation phase withdrawals