What is an Annuity?                                               

An annuity is a contract issued by an insurance company. It is usually referred to as an annuity policy or an annuity contract. What makes annuities unique in the investment community is the tax treatment given them by the IRS.

Think of an annuity as an umbrella. When money is placed under the annuity umbrella it is treated differently for tax purposes.

• The money that you put in an annuity is referred to as a premium. It's your original contribution or deposit, or principal contribution. Since you have already have paid taxes on your contribution, it will never again be subject to taxation. This assumes that you haven't purchased an annuity as part of a qualified retirement program such as an IRA or 401(k).
• The money that you put into an annuity may earn interest or receive dividend income or capital gain distributions. These "earnings", unlike cash in a savings account, mutual fund, or certificate of deposit are not taxed in the year in which they are earned, but rather in the year they are withdrawn.. Thus the "earnings" will continue to grow and compound tax deferred.

Types of Annuities - Investment Options

There are two type of annuities fixed annuities and variable annuities. What distinguishes the two are the investments options and guarantee provisions available within them.  

• Fixed Annuities
  A fixed annuity offers a current guaranteed interest rate for a specified period of time. Once that time period expires, the company will set a new rate (renewal rate) which may be higher or lower than the original rate.

  The annuity policy has a guaranteed minimum interest rate which is specified in the contract and at no time may the current or renewal interest rate fall below it.

• Variable Annuities
  Variable annuities offer two types of "investment accounts".
  • Fixed Account
    Which is a Fixed Annuity with all the guarantees of the product described above. However there are not as many interest rate durations as buying the product on it's own.
  • Separate Account
    Is the investment portion of the product which offers what are essentially a series of "mutual funds" to chose from. The product usually offers a number of "family of funds" with numerous individual funds.

    In summary, a variable annuity provides a way to buy mutual funds on a tax deferred basis.

Insurance Elements of an Annuity

Both fixed and variable annuities provide "insurance elements" which can only be found in a product issued by an insurance company.

• Death Benefit
  Variable Annuities offer a guarantee that in the event of your death, your beneficiary will receive at least all the premiums you have paid less any withdrawals you have made regardless of the value of your account. This means that if you invest money in a variable annuity and put your money in one of the "mutual funds" and at the time of your death it is worth less than your original investment, your beneficiary will get back your original investment.

• Lifetime Income
  Both fixed and variable annuities offer an option which will give you a guaranteed lifetime income for as long as you live.
  
  

  Taxation of Annuities

  The IRS eventually collects taxes on the "earnings" of your annuity.

  • When you withdraw money from your annuity, the earnings, according to the IRS, are withdrawn first. The "earnings" are subject to "ordinary income taxes" in they year in which they are withdrawn. Keep in mind that capital gain distributions in a mutual fund are taxed at capital gains rates.
  • The IRS also has what it calls  "Premature Distributions". If you withdraw your earnings before you reach age 59 1/2, not only are your earnings taxed at ordinary income tax rates, the IRS makes you pay a penalty of an additional 10% of the earnings withdrawn.
• However there are no penalties on distributions:
  • Made after your 59 1/2 birthday.
  • Made on or after the death of the owner of the annuity.
  • If you should become disabled.
  • As part of a series of substantially equal periodic payments (not less than annually) for the life (or life expectancy) of the taxpayer or joints lives (or joint expectancies) of the taxpayer and his or her designated beneficiary.
  • Made under a single premium immediate annuity with a starting date no later than one year from the purchase date.
  • Made under certain annuities issued in connection with structured settlement agreements.

Avoid Probate
If a premature death should occur, the accumulated funds within your annuity may be transferred to your named beneficiaries, avoiding the expense, delay, frustration and publicity of the probate process. Like most assets, the annuity is part of your taxable estate. Your heirs can chose to receive a lump sum payment, or a guaranteed monthly income.