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What is an annuity?
An annuity is a contract between you and your insurance company that allows your earnings to grow and compound tax-deferred. Tax deferral is a powerful benefit you can use to help accumulate wealth for your retirement or meet other long-term financial goals.
The word “annuity” literally means “annual payments.” An annuity has an accumulation phase as well as a payout phase. When you buy an annuity, the insurance company agrees to pay you an income for a specified period of time – either beginning immediately (an immediate annuity) or after an accumulation period ends (a deferred annuity).
How is an annuity structured?
In general, there are three parties to an annuity (plus the insurance company): the owner, the annuitant, and the annuitant's beneficiary.
The owner controls incidents of ownership in an annuity and has the right to the cash surrender value. The owner also can name the beneficiary, assign the policy, and make withdrawals. Often, the owner is also the annuitant.
Most importantly, the owner is the party who receives the tax benefit of the annuity during the accumulation phase of the contract. The owner does not pay annual taxes on the income earned (the tax deferral); however, the owner does pay taxes on withdrawals made during the accumulation phase. The owner is typically the person who receives the payments during the income phase.
The annuitant is the person on whose life the terms of the annuity are measured. Again, the annuitant may also be the owner. Our contracts are annuitant-driven. This means that when the annuitant dies, the annuitant's beneficiary is the recipient of the death benefit.
What types of annuities are available?
There are two main annuity types: deferred and immediate.
With an immediate annuity, your income payments start right away. You choose whether you want income guaranteed for a specific number of years or over your lifetime. The insurance company calculates the amount of each income payment based on your purchase amount and your life expectancy.
A deferred annuity has two phases: the accumulation phase, during which you let your money grow, and the payout phase, during which you begin to receive scheduled payments. During accumulation, earnings grow tax-deferred until withdrawn. You decide when to take income from your annuity, and therefore, when to pay the taxes.
The payout phase begins when you withdraw income from your annuity. For most people, this is during retirement. As your needs dictate, you can take partial withdrawals, completely surrender your annuity, or convert your annuity into a stream of income payments (known as annuitization). This last option is essentially the same as buying an immediate annuity.
What are the annuity payout options?
Whether you’re buying an immediate annuity or converting a deferred annuity into income payments, your options are essentially the same. You can choose to receive payments monthly, quarterly, semiannually, or annually. You can select a specific period of time in which to receive payments. You can also choose an option that will guarantee income payments for as long as you live.
Are there annuity tax advantages during the payout phase?
When you buy an immediate annuity or “annuitize” a deferred annuity, a portion of each payment is considered earnings, and a portion is a tax-free return of your principal. You are only subject to taxes on the portion of each payment that represents earnings. Once enough payments have been made that you recover all of your tax-free principal, each additional payment will be fully taxable. There are other ways you can access the accumulated value in your annuity. For example, instead of annuitizing, you may want to take withdrawals. In that case, distributions represent taxable earnings first. After all earnings are distributed, tax-free return of principal remains.
If your annuity is inside an IRA, 401(k), or other qualified retirement plan, 100 percent of each payment will be subject to taxes (unless a distribution represents after-tax contributions into the plan). You should consult your tax advisor regarding your particular situation.
What other ways can I access my money in an annuity?
Most annuities allow withdrawals at least once a year (usually 10 to 15 percent of the accumulated value in your annuity) without a company withdrawal charge. Another way to receive income from your annuity is through systematic withdrawals.* A systematic withdrawal program allows you to enjoy a steady stream of income on a monthly, quarterly, semiannual, or annual basis. Unlike annuitization, which is a permanent decision, systematic withdrawals allow you to start and/or stop your income payments as your needs dictate. You can have the amount of your payments increased or decreased – it's up to you. Systematic withdrawals give you added flexibility without giving up control of your money or your taxes. Systematic withdrawals tax your earnings first. So when all of your earnings have been exhausted, tax-free return of principal remains.
Annuity guarantees are subject to the claims-paying ability of the issuer. Unlike contributions to a qualified retirement
plan, money you invest in an annuity is not tax deductible. Any money
that you use to purchase an annuity will be after-tax income. (However, like a qualified retirement plan, interest and
capital gains earned by an annuity will accrue tax deferred until you begin withdrawing the money from the annuity.) Many annuities
have high "back-end" surrender charges if you withdraw your money from the annuity within the first
few years. In many instances, the surrender charge may be 8 percent of any money you withdraw in the first year,
then 7 percent of any money you withdraw in the second year, and continuing down to zero by the ninth year.
Another concern when purchasing annuities is that the tax code imposes a 10 percent penalty tax (in addition to any
other taxes owed on the payments) on withdrawals of any earnings from an annuity before you reach the age of
59ó. There are certain exceptions to the imposition of this penalty, but in most cases you will have to pay an
additional tax penalty if you withdraw earnings from the annuity before you reach the cut-off age.