What are Annuities

Annuities act in opposition to life insurance. While life insurance protects you financially against an early or unexpected death, annuities protect you from the financial risk of living too long and outliving your money. There are different types of annuities including immediate, deferred, fixed, and variable. Annuities are a special form of investment that is a contract between, the investor, and the issuing insurance company, that states that the insurance company will pay you a series of payments for either a specific period of time or for the rest of your life.

In the past, a life annuity contract consisted of a person paying an insurance company a specified amount of money in exchange for the guarantee that the insurance company would make periodic payments to this person for the rest of his or her life, thus ensuring that this person wouldn’t outlive his or her money.

However, individual annuity contracts these days allow the payout of accrued money in different ways. Generally, very few individual annuity contracts are actually taken as life income, or annuitized.

Annuitant—The individual who receives the payout of an annunity

Premium—The amount of money paid to the insurer for the annunity. This can be paid over time or in a single lump sum.

Owner—The individual who enters into an annunity contract with the insurer. This person may differ from the annuitant.

Beneficiary—The person named by the owner who would receive the death benefit from the annuity upon the owner’s death.

Annuities are very much like IRAs, in that the money grows taxdeferred, and the annuity owners cannot take any distributions from the contracts until they are at least 591/2 years old. All money invested in an annuity is done so after tax, and there is no tax deduction for investing in an annuity unless it is done inside an IRA annuity. Then, any tax deduction is subject to the same limits that other IRA contributions are subject to (i.e., $3000 per year). In most cases, those who take money out of their annuity contracts before they are 591/2 will face a 10-percent IRS penalty for early withdrawal, plus they will be responsible for taxes on the money that was withdrawn. Taxes are paid at ordinary income rates, regardless of how long the annuity has been held.

For nonqualified annuities (those not within an IRA plan), the annuity owner’s investment in the contract is the total premium amount paid, less any nontaxed distributions. Because the contract owner has paid in after-tax dollars, he or she (or the beneficiary, after the owner’s death) is entitled to have this amount back tax-free once distributions from the annuity begin. Therefore, hypothetically, if the owner puts in a total of $75,000, once he or she begins receiving payouts from the annuity, the owner will receive a total of $75,000 back tax-free. (Alternative minimum tax, state and local taxes may apply.) If the annuity is worth $87,000 at the time it is annuitized, the owner may only be taxed on the growth, $12,000.

Because the annuity grows tax-deferred, any movement of money within a variable annuity will not be considered for capital gains taxes. For example, you have $20,000 in the Growth subaccount, which is doing very well. You want to protect some of the money you have earned from this subaccount and wish to move $5000 to the Fixed subaccount. The transfer of the $5000 from the Growth subaccount to the Fixed subaccount is done completely taxfree. You won’t be taxed on the gain from the Growth subaccount.

IMMEDIATE ANNUITIES

Immediate annuities require the annuitant to pay a lump sum of money, rather than paying a number of premiums over time. The payouts to the annuitant begin as soon as the lump-sum payment is received, or the annuity start date. This date is the first day of the first period (i.e., month) for which an amount is received as an annuity, under the current tax law. A likely use of an immediate annuity is by someone who is about to retire and would like to receive monthly income right away. An immediate annuity can be paid out in either fixed or variable amounts.

DEFERRED ANNUITIES

In contrast to immediate annuities, deferred annuities can have one lump-sum payment by the annuitant, or the annuitant can pay a set of premiums over time. The payouts for deferred annuities typically don’t start for at least one year after the purchase payments have ended. Usually, payouts don’t occur until many years later. However, just with immediate annuities, the payouts may be either fixed or variable. Deferred annuities make up the larger segment of annuity contracts that are purchased due to the IRS rules governing annuity payouts, as well as the desire by investors to take advantage of any potential tax-deferred growth.

SPLIT-FUNDED ANNUITIES

This is combination of an immediate and deferred annuity. This approach provides for a portion of the annuity to revert back to the owner as immediate income for a fixed period of time, or for life. The remaining money in the annuity grows tax-deferred, as a regular deferred annuity would. Split-funded annuities act as a good hedge against inflation since the deferred portion can be used in the future as additional income, if necessary.

FLEXIBLE-PREMIUM ANNUITIES

As the name implies, flexible-premium annuities are those in which the annuity owner has discretion over when the premium payments begin. The owner may also decide if, when, and how much the premium payments may change; they may also decide to stop paying the annuity’s premium. This type of annuity is only for deferred contracts.

SINGLE-PREMIUM ANNUITIES

These annuities are purchased with one lump-sum payment, rather than premiums over time. The premium may be paid just prior to the annuity’s payouts (for an immediate annuity), or it may be paid much earlier (for a deferred annuity). Both single-premium immediate and single-premium deferred annuities may be paid out in fixed or variable amounts.