MR. WATSON: There are two ways to get your money out of the annuity. 

• Take a withdrawal,  (take your own money, like an ATM), or
• You can annuitize. Annuitize means you open up the spigot and it starts paying you a steady stream of income.

Withdrawals

MR. WATSON: Now let’s talk about withdrawals.  Example: Taking a withdrawal from an annuity is like drinking a beer.  

• The beer is the principal,
• The foam is the interest,
• When you drink the beer (withdrawal) you get the foam (interest) first, and
• If you drink beer too young there is a penalty (taking a withdrawal before 59 1/2 has a penalty).

MR. WATSON: The beer in the glass is what you put in (the principal). The foam is the interest you have earned, which was not taxed while it was growing. You only pay taxes on the gains (the foam) when the money comes out of the annuity. When you take a withdrawal (drink the beer), the foam comes out first, (the interest) and will be taxed LIFO.  LIFO is Last In, First Out - so the Last, or most recent, thing to go in the bucket (the interest), is the First thing to come Out when you take a withdrawal. So, you put in $10,000 (the beer, which has already been taxed). It made foam (interest) of $5000. Any money you withdrawal will come from foam first, which is the interest first.

STUDENT: Every time?

MR. WATSON: Yes. So let’s say you take a $7,000 withdrawal. You had $10,000 in principal (what you put in) and $5,000 in interest for a total of $15,000 in the bucket, and you take a $7,000 withdrawal. You will have to claim $5,000 of the withdrawal as taxable income because we took from the interest first. The other $2,000 of the withdrawal is tax-free because that was your money, the principal.

MR. WATSON: Now, if you drink beer too young you will have a penalty, right?  Same if you take a withdrawal too young, before age 59 1/2. If you took the $7,000 withdrawal before you’re 59 1/2, you will not only have the income taxes we just mentioned, but you will also have a 10 percent penalty on the full $7,000. Don't confuse penalty with taxes. The penalty is the 10% on the total amount withdrawn and the income taxes are only on the gain, the interest portion.  Not only that, but the insurance company will also impose a surrender charge if money is withdrawn within the early years of the contract, typically the first five to eight years. Normally, the insurance company would be able to invest the annuity and keep part of the interest for their profits for years.  But if the annuitant takes a large chunk of the money in the early years (more than 10%), that can make a big impact on how much the company makes and so they will charge the consumer for that.

MR. WATSON: This is why insurance companies always want to see the customer's liquidity when they are selling an annuity, because they need to see that the consumer has other cash that’s readily available in other places so they won’t have to take money from the annuity if there is an emergency. Liquidity means liquid cash that’s immediately accessible, like savings and checking accounts, money markets, income sources, etc. The insurance company will also look at things like the customer’s income, tax status, objectives, time horizon and risk tolerance before recommending an annuity to someone.

 

Annuitizing

MR. WATSON:  But what if I want to annuitize?  If I want a steady stream of money for the rest of my life, I would annuitize.
(Mr. Watson opened the spigot on the water cooler and water is pouring out all over the floor.)

MR. WATSON: Can I stop it? I can't stop it. The only way to stop it is to what? Die. Guys, when you annuitize it, how do you stop it?

STUDENTS: Die.

MR. WATSON: When you are annuitizing, can you stop the flow? No. It will pay you for as long as you live. The time that you are putting money into the annuity is called the accumulation phase. If you annuitize and get a steady stream of income that is called the annuity phase. There are two ways to take it out of the annuity - either withdrawal or annuitize. So when you annuitize, the money only stops with death.  And we have different payout options so that the insurance company knows what to do with the money if you die early, but we’ll get to those in a minute.

MR. WATSON:  We said a minute ago that if you take a withdrawal before age 59-1/2 there's a 10 percent penalty. If you take a withdrawal before age 59-1/2, there is a 10 percent penalty. There is NO penalty for annuitizing, at any age. Know this, it is on the exam.

MR. WATSON: If I annuitize - If I annuitize, let's say, at age 48, what's the penalty?

STUDENTS: 10 percent. (WRONG)

MR. WATSON: No! No! No!

MR. WATSON: What did I say? I said I annuitize at 48. There is no penalty. Because I annuitized. I did not withdraw. You understand? 

MR. WATSON: There's two ways to take your money out- withdrawal or annuitize. If you annuitize - at any age; at 10, at 20 - there's no penalty. There will be taxes on the interest, but no penalty. Watch out for the difference between taxes and penalties. Two different words, two different meanings. You ALWAYS pay income taxes on the interest portion when the money comes out of the annuity. It doesn’t matter if you withdraw or annuitize - you always pay income taxes on the interest portion.  The 10% penalty only applies to withdrawals.  Be careful!

STUDENT: After you annuitize, you cannot deposit any more money into the account?

MR. WATSON: Correct. There's nothing there. You traded your bucket of cash for a lifetime income. You no longer have a bucket of money because you’ve traded it for a lifetime of income.  The company takes your money and invests it, and they give you a promise that they will pay you for as long as you live, no matter how long that is. Does that make sense?

STUDENT: Um-hmm.