An annuity is a tax-deferred investment sold by annuity companies to help investors supplement other retirement income. There are two annuity structures: an immediate annuity and a deferred annuity. Of the deferred annuities, an investor may purchase a fixed or variable annuity.
Each of these options affects principal in different ways. It helps to understand the treatment of principal in annuities so that you can protect your original investment for retirement.
Qualified vs. Non-Qualified Annuities
In an annuity, because the contract is with an insurance company, the annuity owner pays premiums. These premiums may be paid in a lump sum, in periodic payments, or in regular contributions.
An annuity can be either qualified as in an employer sponsored plan or non-qualified. In qualified annuities, the principal is pretax dollars and will grow deferred, taxed upon liquidation. Their premiums may also be tax-deductible.
In non-qualified annuities, the principal is the base that earnings are generated on, but as after-tax premiums will not be taxed upon distribution. For that reason, the premiums are not tax-deductible. However, the earnings are allowed to grow tax-deferred but will be subject to taxation upon distribution.
What Is an Immediate Annuity?
In an immediate annuity, the owner pays one lump-sum premium to obtain an immediate income stream that lasts either for the remainder of the lifetime of the annuitant or for a specified number of years.
When you buy an immediate annuity, you are not able to cancel the contract or adjust it at any period of time. That is because the payments start almost immediately. And annuity companies can pay them monthly, quarterly, or yearly.
For that reason, the principal paid into the contract is absorbed by the insurance company to pay operating expenses and invest to support the income indefinitely.
What Is a Deferred Annuity?
Deferred annuities generate cash value over the course of the annuity contract. When the owner pays premiums, the principal value tends to increase as does the cash value. That is because they will have some time to grow before you begin receiving payments.
With fixed annuities, the principal amount is often guaranteed such that if you liquidate the entire annuity prior to the contract terms, any penalties or fees will only affect earnings, not principal.
However, variable annuities do not offer this same guarantee. When owners invest premiums, the money is placed in mutual fund subaccounts. These accounts are not guaranteed, thus the principal fluctuates with the mutual fund changes.
The Annuity Beneficiaries
Most annuities name beneficiaries on the contract where benefits are paid to the beneficiaries upon the death of the annuitant. Designating these beneficiaries ensures that your annuity does not become part of the probate process, which could be lengthy and costly for them.
With immediate annuities, the contract must have a specific rider that offers a death benefit to pay the beneficiaries the remaining balance of an annuity if a designated number of payments were not made during the annuitant's life – meaning he died prior to realizing the full benefit. These policies still offer a lifetime income stream but may not pay as much as those that don't.
On the other hand, fixed annuities guarantee that the entire cash value is paid to the beneficiaries, which includes the principal and earnings.
However, variable annuities pay beneficiaries the value of the annuity based on the fluctuations. If the principal has increased, the beneficiary will receive the principal plus earnings. If the value went down, the beneficiaries receive what remains.
Final Thoughts on Annuities
Because there are so many types of annuities, there are misconceptions about the investment product. Investors need to discuss specific annuity contract terms with a financial adviser or tax adviser to properly understand how the principal in annuities is affected before deciding what product to invest in.