An annuity is an investment structure offered by an insurance company to an investor. Annuities are recognized by the IRS as a tax shelter to help investors save money toward retirement. They can be used as employer-sponsored retirement plans or as individual accounts to supplement other retirement plans.
Annuities have evolved over the past 200 years. In the United States, the first annuities were sold by the Presbyterian Church, not an insurance company, in 1740, according to Annuity.com. The purpose was to provide an income for widows and clergy members. Today, a wide variety of annuities provide income for a wide range of clients who buy them from insurance companies.
There are two types of annuities: immediate and deferred. Immediate annuities create an immediate income stream for a specific period or for the rest of the annuitant's life. The annuitant is the person upon whose life the annuity benefits are paid, similar to an insured in an insurance policy. Deferred annuities allow an investor to place money into the account and earn interest over time. This interest grows tax-deferred until the money is withdrawn. Deferred annuities can grow at a fixed rate or can be tied into stock market mutual funds.
There are several significant points regarding annuities. The first is that an annuity can provide a lifetime income stream to the annuitant, insuring that he will not outlive his resources. Additionally, tax deferral allows assets to grow faster by eliminating any income or capital gain tax on growth within the annuity. And an annuity avoids probate, giving money directly to beneficiaries once the annuitant dies.
There are four parties to an annuity contract. The owner buys the annuity policy from an insurance company. The other two parties are the annuitant and the beneficiary(ies). The contract benefits are paid based on the annuitant's life. So if the contract is annuitized and income is paid for the lifetime, the amount is based on the life expectancy of the annuitant. If the annuitant dies, the insurance company pays benefits to the beneficiary.
An annuitant can take an income from the annuity at any time during the contract. When assets are removed from the annuity, they are added to ordinary income. If the annuity was an employer-sponsored qualified plan, the entire liquidation is taxed, because contributions to these plans were pre-tax money. If it is a supplemental non-qualified plan in which the principal contributions had already been taxed, only the earnings are added to ordinary income upon withdrawal.