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Annuity

Find information on annuities.

An annuity is an insurance contract. An annuity contract is created when an individual gives the insurance company money which may grow tax deferred and then can be distributed back to the owner in several ways.

Annuity contracts in the United States are defined by the Internal Revenue Code and regulated by the individual states. Annuities have features of life insurance and investment products. In the US, annuity contracts are only allowed to be sold by insurance companies, although private annuity contracts may be arranged between donors to non-profits to reduce taxes. Insurance companies are regulated by the states, so contracts or options that may be available in some states may not be available in others. However, their tax treatment is dictated by the Internal Revenue Code. There are two types of annuity contracts: the immediate annuity, which guarantees payments for a period of years or the lifetime of an individual or couple, and the deferred annuity, which grows tax deferred until such time as the annuity contract is annuitized (converted into an immediate annuity) or cashed in (either in periodic withdrawals or in a lump sum).

Immediate Annuity

The term annuity in financial theory is most closely related to what is today called an immediate annuity. This is an insurance policy which in exchange for a sum of money, makes a series of payments. These payments may be either level or increasing periodic payments for a fixed term of years or until the ending of a life or two lives, or even whichever is longer.

The overarching characteristic of the immediate annuity is that it is a vehicle for distributing savings with a tax deferred growth factor. A common use for an immediate annuity might be to provide a pension income. In the US, the tax treatment of an immediate annuity is that every payment is a combination of a return of principal (not taxed) and income (taxed at normal income rates, not capital gain rates.) When a deferred annuity is annuitized, it works like an immediate annuity from that point on, but with a lower cost basis and thus more of the payment is taxed.

Annuity with Period Certain
This type of Immediate Annuity pays the annuitant for a designated number of years, and is used to fund a need that will end when the period is up (an example of this might be a life insurance policy). Thus this option is not necessarily suitable for an individuals retirement income, as the person may outlive the number of years the annuity will pay.

Life annuities
A life or lifetime immediate annuity is used to provide an income for the life of the annuitant, i.e. a pension.

This annuity works somewhat like a loan that is made by the purchaser to the issuing company, who then pays back the original capital (which isn't taxed) with interest (which is taxed as income) to the annuitant on whose life the annuity is based. The assumed period of the loan is based on the life expectancy of the annuitant. In order to guarantee that the income continues for life, the insurance company relies on a concept called cross-subsidy. Because an annuity population can be expected to have a distribution of lifespans around the population's mean (average) age, those dying earlier will give up income to support those living longer who's money may otherwise run out.

A life annuity is most commonly used to transfer the risk that the annuitant will run out of money to the insurance company. Sometimes a portion of that money will purchase a life insurance policy which will guarantee that the heirs of the annuitant still receive an inheritance.

Life annuity variants
At a cost to the payments, an annuity contract rider can be purchased with addition of another life such as a spouse on whose life the annuity is wholly or partly guaranteed. For example, it is common to buy an annuitie which will continue to pay out to the spouse of the annuitant after death, for as long as the spouse survives. The annuity paid to the spouse is called a reversionary annuity or survivorship annuity. However, if the annuitant is in good health, it may be more beneficial to select the higher payout option on their life only and purchase a life insurance policy that would pay income to the survivor.
Other features such as a minimum guaranteed payment period irrespective of death, known as life with period certain, or escalation where the payment rises by inflation or a fixed rate annually can also be purchased.

Life with period certain annuities are more palatable to people who have accumulated money and would not like to lose all of it if they were to die soon after annuitization. At least the period certain payments will be made to their beneficiary. However, a viable alternative is to purchase a single premium life policy that would cover the lost premium in the annuity.

Deferred Annuity

The second usage for the term annuity came into being during the 1970s. This contract is more correctly referred to as a deferred annuity and is chiefly a vehicle for accumulating savings, and eventually distributing them either in the manner of an immediate annuity or as a lump-sum payment.

All varieties of deferred annuities owned by individuals have one thing in common: any increase in account values is not taxed until those gains are withdrawn. This is also known as tax-deferred growth.
A deferred annuity which grows by interest rate earnings alone is correctly called a fixed deferred annuity (FAs). A deferred annuity that permits allocations to stock or bond funds and for which the account value is not guaranteed to stay above the initial amount invested is correctly called a variable annuity (VAs).

A new category of deferred annuities has emerged in 1995, called equity indexed annuity (EIA). Equity indexed annuities are a hybrid of the two types of deferred annuities just described. The insurance company typically guarantees a minimum return for EIA. An investor can still lose money if he or she cancels the policy early, before a "break even" period. An EIA's rate of return is equal to the "participation rate" multiplied by a target stock market index's performance excluding dividends. Interest rate caps, or administrative fee may be applicable.

There are two phases to a deferred anniuty. The accumulation phase is the time between initial purchase and annuitization. The annuitization phase starts when the annuity is turned into a stream of payments. Before annuitization, the deferred annuity contract may allow additional purchase premium payments to be added, increasing the contract's value.

A wide variety of features and guarantees have been developed by insurance companies in order to make their annuity products more attractive. These include death benefit options and living benefit options.
Deferred annuities in the United States have an advantage that all capital gains and income are tax deferred until withdrawn. In theory, this allows more money to be put to work while the savings are accumulating, leading to higher returns. A disadvantage, however, is that when a variable annuity is inherited or received as income the beneficiary must pay regular income tax on the gains above the invested cost basis.

Taxation

In the U.S. Internal Revenue Code, the growth of the annuity value during the accumulation phase is tax deferred, that is, not subject to current income tax for annuities owned by individuals. The tax deferred status of deferred annuities has led to their common usage in the United States. Under the US tax code, the benefits from annuity contracts do not always have to be taken in the form of a fixed stream of payments (annuitization), and many of the contracts are bought primarily for the tax benefits rather than to get a fixed stream of income. If an annuity was used in a qualified pension plan or an IRA funding vehicle, then 100% of the annuity payment is taxable as current income upon distribution. If the annuity contract is purchased with after-tax dollars, then the contract holder upon annuitization recovers his basis pro-rata in the ratio of basis divided by the expected value according to the IRS regulations from Section 1.72-5. After the taxpayer has recovered all his basis, then 100% of the payments thereafter are subject to ordinary income tax.

This article is licensed under the GNU Free Documentation License. It uses material from the Wikipedia article "Annuity (US financial products)".