Overview: Annuities serve specific individual and business purposes that go well beyond simple retirement savings. Understanding these applications prepares you for both exam scenario questions and real client conversations.

Structured Settlements

When a personal injury claim is settled, the defendant (or their liability insurer) may fund a structured settlement by purchasing an annuity. The annuity is designed to match the plaintiff's financial needs — regular living expense payments, lump sums timed to anticipated medical procedures, or inflation-adjusted amounts.

The tax advantage is significant: under IRC Section 104(a)(2), compensatory damages received for physical injury or physical sickness are excluded from gross income. Crucially, this exclusion extends to all earnings within the annuity as well — both principal and growth are paid completely income-tax-free. This stands in stark contrast to a lump sum settlement, where any subsequent investment gains are fully taxable.

Structured settlements also protect plaintiffs from dissipating large sums quickly, provide guaranteed lifetime income for catastrophically injured individuals, and can be designed to feed a Special Needs Trust so that government benefits like Medicaid and SSI are preserved.

Retirement Income Planning

A deferred annuity functions as a fourth income source in retirement alongside Social Security, an employer pension, and personal savings. It is especially valuable when:

The client wants to fill a specific income gap without depleting investment accounts
The client wants to delay Social Security to age 70 for maximum benefit — a deferred annuity can bridge the gap from retirement to age 70
The client has maxed out other tax-advantaged accounts and needs additional tax deferral
The client faces "sequence of returns risk" and wants a guaranteed floor that allows equity assets to remain invested during market downturns

Joint and Survivor Annuities in Business Succession

A business owner can sell their business interest to a successor in exchange for a private annuity — a personal obligation of the successor to make lifetime payments to the seller and, if structured as a joint and survivor arrangement, to the seller's spouse after the seller's death. This removes the business value from the seller's taxable estate (no more estate tax on that asset) and avoids the need for the successor to secure a large upfront acquisition loan. Payments are funded by the business's own cash flow.

Business Overhead and Key Person Strategies

Annuities play a limited but specific role in business planning. They are excluded from reimbursable expenses under standard Business Overhead Expense (BOE) disability insurance — a BOE policy will not pay annuity premiums during an owner's disability. However, annuities work effectively as informal funding vehicles for:

Nonqualified Deferred Compensation (NQDC) plans: A company owns an annuity naming a key executive as annuitant; at retirement, the annuity funds the company's promised income stream.
Section 162 Executive Bonus plans: The company pays the premium on a personal annuity owned by the executive, which retains its tax-deferred status (because a natural person owns it) and eventually provides retirement income.

Estate Planning Considerations

Annuities pass to named beneficiaries outside of probate, providing an efficient transfer mechanism. However, several estate planning features distinguish them from other assets:

Annuities do not receive a step-up in cost basis at death. Beneficiaries owe ordinary income tax on all accumulated earnings, which can create a significant income tax liability.
Naming an individual as beneficiary generally allows for better tax deferral (including "stretch" provisions for non-qualified annuities) and typically lower tax brackets on distributions.
Naming a trust provides control over distributions, creditor protection, and planning for minors or disabled beneficiaries — but usually accelerates the distribution timeline (commonly forcing payouts within 5 years) and subjects retained income to compressed trust tax brackets (the 37% top rate triggers at around $15,200 for trusts).