What is an Annuity?

An annuity is a contract between you and an insurance company where your earnings are allowed to grow and compound without current taxes. This is a powerful benefit that you can use to help you accumulate wealth for your retirement or other long-term financial goals.

The word annuity literally means "annual payments" and when you buy an annuity, the insurance company agrees to pay you an income for a specified period of time. Whether these income payments start right away, or at some future date, determines what type of annuity you have:

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Two Main Annuity Types: Immediate and Deferred

Immediate Annuity

With an immediate annuity, your income payments start right away (technically, anytime within 12 months of purchase). You choose whether you want income guaranteed for a specific number of years or for your lifetime. The insurance company calculates the amount of each income payment based on your purchase amount and your life expectancy.

Deferred Annuity

A deferred annuity has two phases: the accumulation phase, where you let your money grow for a while, and the payout phase. During accumulation, your money grows tax-deferred until you take it out, either as a lump sum or as a series of payments. You decide when to take income from your annuity and therefore, when to pay the taxes. Gaining increased control over your taxes is one of the key benefits of annuities.

The payout phase begins when you decide to take income from your annuity. For most people, this is during retirement. As your needs dictate, you can take partial withdrawals, completely cash-out (surrender) your annuity, or convert your deferred annuity into a stream of income payments (annuitization). This last option is essentially the same as buying an immediate annuity.

Think of an annuity as an umbrella. When money is placed under the umbrella or annuity contract, it is treated differently as far as taxes go.

  • The money that you put in an annuity is referred to as a premium, it's your original contribution or principal contribution. Since you already have paid taxes on it, it never again will be subject to taxation. This assumes that you haven't purchased an annuity as part of a qualified retirement program such as an IRA, 401(k), TSA or 457 plan.
  • The money that you put into an annuity will earn interest or receive dividend income or capital gain distributions. These "earnings", unlike money in a savings account, mutual fund, certificate of deposit are not taxed in the year in which they are earned. Thus the "earnings" will continue to grow and compound tax free until withdrawn.

However there are no penalties on distributions:

  • Made after your 59 1/2.
  • Made on or after the death of the owner of the annuity.
  • If the taxpayer becomes disabled.
  • A part of a series of substantially equal periodic payments (not less than annually) for the life (or life expectancy) of the taxpayer or joints lives (or joint expectancies) of the taxpayer and his or her designated beneficiary.
  • Made under a single premium immediate annuity with a starting date no later than one year from the annuity purchase date.
  • Made under certain annuities issued in connection with a structured settlement agreements.

Avoid Probate

If a premature death should occur, the accumulated funds within your annuity may be transferred to your named beneficiaries, avoiding the expense, delay, frustration and publicity of the probate process. Like most assets, the annuity is part of your taxable estate. Your heirs can generally chose to receive a lump sum payment, or a guaranteed monthly income.

What is a Fixed Tax-Deferred Annuity?

A Fixed Tax-deferred annuity, also referred to as a tax-deferred annuity, is a contract between you and an insurance company for a guaranteed interest bearing policy with guaranteed income options. The insurance company credits interest, and you don't pay taxes on the earnings until you make a withdrawal or begin receiving an annuity income. Your annuity contract earns a competitive return that is very safe.

Tax-Deferred?

Tax-deferred means postponing your taxes on interest earnings until a future point in time. In the meantime you earn interest on the money you're not paying in taxes. You can accumulate more money over a shorter period of time, which ultimately will provide you with a greater income.

Savings Advantages

Many people today are using tax-deferred annuities as the foundation of their overall financial plan instead of certificates of deposit or savings accounts. Although CD's and Annuities are very similar there are significant differences between the two. The most important difference is that annuities allow for the deferral of the taxes due on the interest earned until the interest is withdrawan. By postponing tax with a tax-deferred annuity, your money compounds faster because you can earn interest on dollars that would have otherwise been paid to the IRS. Later, if you decide to take a monthly income, your taxes can be less because they will be spread out over a period of years. Like Certificates of Deposits, annuities have a penalty for early surrender, however most annuity contracts have a liberal "free withdrawal" provision.

Tax Advantages

You pay NO taxes while your money is compounding. You can also pay a lower tax on random withdrawals because you control the tax year in which the withdrawals are made, and only pay taxes on the interest withdrawn. Tax deferral gives you control over an important expense - your taxes. Any time you control an expense, you can minimize it. The longer you can postpone this particular expense, the greater your gain when compared to the gain you would make with a fully taxable account.

The Tax-Deferred Advantage

To illustrate the increased earnings capacity of tax-deferred interest, compared below to fully-taxable earnings. $25,000 at 6.0% will earn $1,500 of interest in a year. A 28% tax bracket means that approximately $420 of those earnings will be lost in taxes, leaving only $1,080 to compound the next year. If these same earnings were tax-deferred, the full $1,500 would be available to earn even more interest. The longer you can postpone taxes, the greater the gain.

Tax-Deferred vs. Fully Taxable

Compare the Return

$107,297 Accumulated in a Tax-Deferred Annuity

$71,966 Accumulated in a Taxable Account

The Difference:$35,331

Note: That at an annuity's guaranteed rate of 4%, the return after 25 years would be $66,646.

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Safety

Your tax-deferred annuity is safe. A qualified legal reserve life insurance company is required to meet its contractual obligations to you. These reserves must, at all times, be equal to the withdrawal value of your annuity policy. In addition to reserves, state law also requires certain levels of capital and surplus to further increase policyholder protection. Legal reserve refers to the strict financial requirements that must be met by an insurance company to protect the money paid in by all policyholders. These reserves must be at all times, equal to the withdrawal value (principal plus interest less early withdrawal fees, if any) of every annuity policy. State insurance laws also require that a life insurance company must maintain certain minimum levels of capital and surplus, which provide additional policyholder protection.

No More 1099's

There is no withholding tax while your annuity is compounding; it is completely tax-deferred. If you request a distribution (random withdrawals or annuity income), taxes will be withheld - unless you elect differently. Your election not to withdraw can be made at the time you make your request. Because the interest is tax-deferred, it is not necessary to issue a From 1099 while your money is compounding. Only when your interest is distributed (withdrawal or annuity income) will a Form 1099 be sent, reflecting the amount of interest actually received.

When Does My Money Mature

An annuity policy does not "mature" like a bond or Certificate of Deposit. Both your principal and interest will automatically continue to earn interest until withdrawn or you reach age 100. You can let your money continue to grow, make withdrawals, or begin receiving an annuity income at any time.

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