An annuity is a type of policy issued by an insurance company designed to accept and grow funds, and upon annuitization, create a stream of income or payments. The money you pay in can be either a lump sum or a number of payments. These contributions generally earn a rate of return, generally tax-deferred.
There are two main ways to categorize annuities: immediate vs. deferred annuities and fixed vs. variable annuities. The immediate vs. deferred category has to do with when your income payout begins. The fixed vs. variable category has to do with how your contributions are invested.
With an Immediate Annuity, your money provides guaranteed payments to you that begin soon after you make your initial payment. Depending on the tax-qualified or non-tax-qualified status of your annuity, a portion or the entire payment can be included in your taxable income. The owner can elect to receive guaranteed payments for life, or elect payments to be made over a specified length of time (period certain).
With a deferred annuity, your income payments are usually put off for a period of time allowing the money you've contributed to earn interest generally tax-deferred. You choose when you want to start receiving income payments — typically, upon retirement.
With a Fixed Annuity, the insurance company places money in high quality fixed-rate investments such as bonds, where the insurance company will earn a fixed interest rate for a certain period of time. For most fixed annuities, the insurance company guarantees a minimum interest rate that you will earn, often for a specified period of time. With a Fixed Annuity, the insurance company is taking the investment risk.
With a Variable Annuity, money is placed in market-based investments. This may include stocks, bonds, mutual funds, or money markets. You may have the option to move the money around among the different investments. In addition, the rate of return can vary based on the performance of the investments. With a Variable Annuity, the risk is taken by the annuitant, rather than by the insurance company.
Deferred annuities can also be a good way to help increase your retirement savings. The tax-deferral and compounding of interest provided by an annuity can help it to grow larger than an equal investment in a taxable account. Gains will be taxed as ordinary income once the money is withdrawn. Annuities can also be used to fund traditional IRAs, Roth IRAs, and Simplified Employee Pension Plans. When an annuity is used to fund a tax qualified retirement plan or IRA, the tax deferral is provided by the retirement plan or IRA and not the annuity. You should contact your attorney or tax adviser for more complete information.