With their many features and types, annuities may seem confusing at first. However, they can play an important role in assisting individuals in their retirement years. Take a few minutes to understand annuities and determine if they may be right for you.
Annuities can be categorized as either an immediate annuity or deferred annuity. An immediate annuity provides income payments shortly after you make the initial annuity payment. A deferred annuity delays annuitization, which provides more time and opportunity for your money to grow tax deferred.
Deferred Annuities
The main choices you have when purchasing an annuity are fixed annuities, variable annuities, or index annuities. These types of annuities are generally deferred annuities. Deferred annuities are designed to offer investors tax-deferred growth and a lifetime stream of income. There are two phases of a deferred annuity:
- Accumulation Period. The period of time when you are making annuity contributions and building the value of the annuity account.
- Annuitization Period. The period of time when the annuitant begins to receive payments from the annuity.
Immediate Annuities
Immediate annuities are single-payment annuities. Any large sum of cash can be converted into an income stream for the duration you specify.
With an immediate annuity you can turn your assets into regular payments beginning now and lasting for the rest of your life or for a specified period of time. At retirement you can use distributions from defined contribution plans, 401(k)s or IRAs to fund an immediate annuity and create a personal pension.
Annuity Payment Options
Individuals interested in purchasing an annuity have the option of making a single, lump sum payment or setup a schedule of contributions in varying amounts. Unscheduled payments may be accepted as well. The schedule and types of payments can vary by product. Make certain before purchasing an annuity that you understand the payment options available.
Tax Treatment of Annuities
While annuities are in the accumulation phase, not taxes are due on the earnings. Depending on the type of annuity interest, dividends, or capital gains are automatically reinvested without incurring local, state, or federal taxes. However, once withdrawn, all earnings are taxed as ordinary income, not capital gains. If an annuity owner takes a withdrawal from an annuity prior to age 59 1/2 a ten-percent tax penalty on the earnings is imposed.
Annuity withdrawals are taken on a last in, first out (LIFO) basis, so earnings are taxed first as ordinary income, while any amount in excess of earnings is taken from the principal amount and is nontaxable. This applies when a lump sum withdrawal is taken. However, depending on the payout option selected, whether it be a lifetime payout or a payout over a specified number of years, the withdrawals are taxed differently.
- Each annuity payment is considered one part principal (nontaxable) and one part rate of interest (taxable).
- Each payment is adjusted by an exclusion ratio, which is a ratio that describes the relationship between the invested amount and total expected return under the annuity contract.
Learn more about the tax treatment of annuities.
Death Proceeds
An annuity pays a death benefit to your beneficiaries during the Accumulation Period and certain options for payment after death during the Annuitization Period. It is subject to income tax for your beneficiary, and may be included in your estate for estate tax purposes.
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