What Is An Annuity?

The word annuity refers to a regular stream of level payments, whose duration may be specific or indefinite. In the United States, the word has come to be identified with multi-purpose insurance contracts terminating in a payment stream. This makes it logical to ask: What is an annuity contract?         

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Definition of an Annuity Contract

An annuity contract involves one or more people and an insurance company. The universal common feature of annuity contracts is the option of the holder or holders to receive assured lifelong income in the form of regular payments from the insurance company. The source of these payments is investments made by the holder(s), either in a lump sum or in a series of contributions to the insurance company. The investment proceeds grow tax-deferred prior to disbursal. When the proceeds are distributed to the holder, investment gains are taxed as ordinary income.

Basic Features of the Annuity Contract

The parties to the contract are the annuity holder and the insurance company. The principal features of the contract include: 

  • Payments made by the holder to the insurance company. These may be regular and periodic or may (in the limit) consist of a single payment. Their duration is specified in the contract. Their purpose is to cover the costs of the company and to provide a source of investment funds.
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  • A period of accumulation, over which time the funds are invested. This time period usually lasts for years but may – in the single-payment case – be trivially short. During this period, the holder’s payments accumulate and enjoy tax-free compound growth. Very limited provision is typically made for withdrawal of funds by the holder; beyond this point, withdrawals subject the holder to penalties by the IRS or the insurance company. Withdrawals by the holder prior to attaining the age of 59 ½ will result in a 10% penalty levy by the IRS, as well as imposition of normal income taxes. Premature withdrawals – those made before expiration of the accumulation period – also incur surrender charges by the issuing insurance company.
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  • A period of distribution, during which the invested proceeds are gradually returned to the holder as regular payments. These annuity payments represent taxable income (and return of principal) to the holder, not capital gains. The payments continue until the holder dies, at which time a beneficiary or beneficiaries named by the holder either receives the remaining proceeds in a lump-sum payment or assumes receipt of the annuity payment stream.

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What Is An Annuity Used For?

Retirement saving is a very common motivation for the purchase of an annuity contract. The prospective retiree wants to provide income for the future, minimize the risk of losing wealth and suffering fluctuations in income. Thanks to the annuity, the holder can achieve not only tax-deferred growth of savings but the assurance of a lifelong income as well.

Advances in medical technology, nutritional science and economic productivity have lengthened human life expectancy so much that the danger of exhausting all assets in retirement is magnified. Annuities are a classic and unique solution to this problem. To learn more about how annuities can protect against the risk of outliving one's retirement saving, see Lifetime Annuity Guide.

Participants in qualified pension and retirement plans already receive tax-deferred growth on their retirement savings, but they can still benefit from annuities. In a defined-contribution company-retirement plan, participants own and control their investments for retirement. Upon retirement, they can withdraw the proceeds and invest them in a single-payment annuity in order to enjoy immediate income that will last them for the rest of their lives. Companies can fund pension obligations under defined-benefit retirement plans by purchasing single-premium annuities for their employees. Governments seeking to privatise public retirement programs can do so by utilizing single-payment annuities that substitute private annuity payments for government transfers.

Annuities figure prominently in legal verdicts and settlements, particularly personal injury cases. Damage awards are often intended to compensate for lost income extending years into the future. An annuity possesses just the right features for the job: regular, consistent payments lasting for the life of the recipient.

Annuities can not only reward plaintiffs, but also insulate potential defendants. The wealth of many business owners and professionals is particularly vulnerable to liability litigation. Most states protect the assets inside life insurance contracts from adverse legal judgments.  In those states, holding wealth in the form of annuities would place it outside the reach of an overzealous plaintiff.

Types of Annuities

Annuities come in various shapes and sizes, geared towards addressing the diverse range of investor needs. The first basic classification is between deferred and immediate annuities. The former accumulates money like a savings account for later withdrawal, whereas the later pays back an initial lump-sum investment plus interest over a period of many years. The second basic difference between annuities is how they accumulate and credit interest, either as fixed, variable, or indexed products. For a more detailed discussion of various annuity types and which one is best suited for you, see Types of Annuities.

Tradeoffs in Buying Annuities

Annuities possess features – such as life expectancy estimates and death-benefits – that require actuarial expertise and calculations. Consequently, they are offered by insurance companies and considered insurance products. Annuity-distributed gains are therefore taxed as ordinary income rather than as capital gains. At current rates, this is disadvantageous; the higher the annuitant’s tax bracket at distribution, the steeper the tradeoff.

Unlike mutual funds, bonds or real estate, annuity assets do not receive a step-up in cost basis to the valuation as of the date of death. Instead, all beneficiaries inherit the taxes that would have been paid by the holder.

These tradeoffs, along with the surrender charges and other expenses incurred by holders of annuities, must be weighed against the benefits of annuities.

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