How to Create an Annuity Step by Step

An annuity is a financial product designed to provide regular income, often used for retirement planning. It allows individuals to invest a lump sum or make periodic payments in exchange for future payouts. The appeal lies in its predictable income, tax advantages, and customization options.

Understanding how to create an annuity involves several steps, from selecting the right type to finalizing payout terms and tax considerations. Each choice affects how the annuity functions and its long-term benefits.

Selecting a Type

Choosing the right annuity depends on financial goals, risk tolerance, and market expectations. Each type offers distinct features that impact growth, risk, and income predictability.

Fixed

A fixed annuity provides guaranteed interest earnings over a set period. The insurance company determines the rate at purchase, ensuring steady growth regardless of market conditions. These annuities appeal to those seeking stability and protection from volatility.

Interest rates are generally higher than traditional savings accounts or certificates of deposit (CDs), ranging from 4% to 6% in 2024, depending on the provider and contract terms. Some contracts offer multi-year guaranteed rates, locking in earnings for a set duration before adjustments.

While fixed annuities offer reliability, they may not keep pace with inflation. Some contracts include optional riders, such as cost-of-living adjustments, to help offset this risk.

Variable

A variable annuity allows investment in sub-accounts similar to mutual funds. Returns fluctuate based on asset performance, introducing both growth potential and market risk. Unlike fixed annuities, earnings are not guaranteed, but the possibility of higher returns attracts those willing to accept volatility.

Investors can allocate funds across asset classes like equities, bonds, or money markets. Some providers offer professionally managed portfolios tailored to risk preferences. Fees are a key consideration, as variable annuities often include management expenses, mortality and expense charges, and administrative costs, which can reduce overall returns.

Regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), variable annuities offer transparency and investor protections. Some include optional features like income guarantees or death benefits, though these typically come with higher fees.

Indexed

An indexed annuity links returns to a stock market index, such as the S&P 500, while providing downside protection. Growth depends on index performance, but insurers impose caps or participation rates that limit earnings.

For example, if an indexed annuity has an 80% participation rate and the S&P 500 gains 10% in a year, the annuity credits 8% interest. If a cap rate of 6% applies, gains above this threshold are not credited. Most indexed annuities include a guaranteed minimum return, ensuring protection against market declines.

These annuities appeal to those seeking moderate growth without full exposure to stock market risks. However, their complexity requires careful review of contract terms, including how returns are calculated and any earnings limitations.

Funding Arrangements

How an annuity is funded affects its structure, tax treatment, and flexibility. Individuals can choose between a single premium or multiple contributions based on financial circumstances and long-term goals.

A single premium annuity requires an upfront lump sum, often used by those with savings, an inheritance, or a retirement account rollover. This approach provides immediate or deferred income without ongoing contributions.

A flexible premium annuity allows multiple contributions over time, making it suitable for those still in the workforce. Payments can be scheduled or made at the policyholder’s discretion, though insurers may impose minimum and maximum contribution limits.

The source of funds also impacts tax treatment. Annuities purchased with pre-tax dollars through retirement accounts like IRAs or 401(k) rollovers grow tax-deferred until withdrawals begin. Annuities funded with after-tax dollars mean only the earnings portion of withdrawals is subject to income tax, while the principal remains tax-free. The choice depends on current tax brackets, expected future income, and overall retirement strategy.

Payout Terms

How an annuity distributes income affects financial security and long-term sustainability. The structure of payouts depends on when distributions begin, how long they last, and whether they continue for beneficiaries.

Immediate annuities begin payments shortly after funding, often within a year, while deferred annuities accumulate earnings before distributions start later. The timing decision depends on whether the annuity is meant to provide income right away or serve as a future financial resource.

Payout duration is another key factor. A lifetime annuity guarantees income for the policyholder’s entire life, ensuring they do not outlive their savings. A period-certain annuity, by contrast, provides payments for a fixed number of years, such as 10, 20, or 30. While this ensures a predictable income stream, payments could end before the policyholder’s death if the term is shorter than their lifespan.

Another consideration is whether payments continue to a spouse or beneficiary. A joint-and-survivor annuity extends income to a surviving spouse after the original annuitant’s death, often at a reduced percentage, such as 50% or 75% of the original payout. Some annuities include a refund provision, guaranteeing that if the policyholder dies before receiving at least the amount they initially contributed, the remaining balance goes to heirs as a lump sum or continued payments.

Tax Obligations

The tax treatment of annuity withdrawals depends on the type of account used for funding and whether the annuity was purchased with pre-tax or after-tax dollars.

Withdrawals from non-qualified annuities, funded with after-tax money, follow the IRS exclusion ratio. This formula determines how much of each payment is considered a return of principal (tax-free) versus taxable earnings. For example, if an annuity was purchased for $100,000 and grows to $150,000, the $50,000 in gains is taxed as ordinary income, while the original contribution is not.

Qualified annuities, funded through tax-advantaged accounts like traditional IRAs or 401(k)s, are fully taxable upon withdrawal since no taxes were previously paid on contributions. These distributions are subject to ordinary income tax rates, which range from 10% to 37%. Additionally, individuals under age 59½ face a 10% early withdrawal penalty unless an exception applies, such as disability or substantially equal periodic payments under IRS Section 72(t).

Documents and Finalization

Finalizing an annuity requires completing paperwork, reviewing contract terms, and ensuring compliance with regulatory requirements. Insurance companies provide a formal annuity contract outlining the terms, including payout structure, fees, surrender charges, and any optional riders. Reviewing this document carefully is important, as annuities are long-term commitments with financial and tax implications. Many contracts include a free-look period, typically ranging from 10 to 30 days, allowing policyholders to cancel without penalties if they change their minds.

Additional documentation may be required depending on the funding source. If an annuity is purchased using funds from a retirement account, a rollover or transfer form must be completed to ensure proper tax treatment. Beneficiary designations should also be confirmed to ensure proceeds are distributed according to the policyholder’s wishes. Once all documents are signed and submitted, the insurer processes the annuity, and funding is allocated based on the selected investment or interest structure.