Annuities are financial contracts between insurers and customers, wherein the insurer takes a large sum of money and then pays it back with interest as an income stream. These payments may begin immediately or be deferred, and the interest rate offered to the buyer or annuitant can be fixed or variable. The duration for which the income is provided can be for life or a set period in years.
Some annuity contracts call for a single lump sum to be paid to the insurer, while others may allow customers to increase the account's value with regular contributions. This second option is a popular retirement plan afforded tax-deferred status. Both contributions and earnings that accrue are allowed to grow without being taxed.
All these possible options give rise to several types of contracts. The most basic option is to make a lump sum payment and immediately start getting an income stream for a specific duration. This contract is often used in legal settlements or other circumstances where someone suddenly gets a big amount, including when a retiree is allowed to withdraw funds from qualified retirement plans.
In such cases, the part of the income stream which is principal coming back to the annuitant is not taxed. However, the earnings included in the payments being made by the insurer are considered as income and taxed accordingly. Note that the tax rate is not based on capital gains, but as an income tax.
The second and more popular type of contract is a deferred annuity. Annuitants can make a lump sum payment or there is an accumulation phase where the account's value grows with tax-deferred contributions and earnings. The distribution phase begins on a specified date, and the payments made to the annuitant are now considered as taxable income.
The best option for ordinary investors trying to pad a retirement nest-egg is a deferred annuity for life with a fixed rate and beneficiary protection. The insurer guarantees a fixed interest rate for funds in the account, which grow faster because of the tax-deferral. It guarantees a decent income for life after retirement. If the annuitant dies before the distributions start, the beneficiary is guaranteed to get a specified amount.
Variable rate annuities are more suitable for investors who need faster growth and want to invest more money than can be contributed to qualified plans like a 401K. Investors can pick and choose from a selection of options like mutual funds, which can hold a portfolio of bonds, stocks, money market instruments, etc. It's important to ensure that a variable annuity contract offers a minimum guaranteed rate of return, regardless of the performance of the underlying investments.
Some annuity contracts call for a single lump sum to be paid to the insurer, while others may allow customers to increase the account's value with regular contributions. This second option is a popular retirement plan afforded tax-deferred status. Both contributions and earnings that accrue are allowed to grow without being taxed.
All these possible options give rise to several types of contracts. The most basic option is to make a lump sum payment and immediately start getting an income stream for a specific duration. This contract is often used in legal settlements or other circumstances where someone suddenly gets a big amount, including when a retiree is allowed to withdraw funds from qualified retirement plans.
In such cases, the part of the income stream which is principal coming back to the annuitant is not taxed. However, the earnings included in the payments being made by the insurer are considered as income and taxed accordingly. Note that the tax rate is not based on capital gains, but as an income tax.
The second and more popular type of contract is a deferred annuity. Annuitants can make a lump sum payment or there is an accumulation phase where the account's value grows with tax-deferred contributions and earnings. The distribution phase begins on a specified date, and the payments made to the annuitant are now considered as taxable income.
The best option for ordinary investors trying to pad a retirement nest-egg is a deferred annuity for life with a fixed rate and beneficiary protection. The insurer guarantees a fixed interest rate for funds in the account, which grow faster because of the tax-deferral. It guarantees a decent income for life after retirement. If the annuitant dies before the distributions start, the beneficiary is guaranteed to get a specified amount.
Variable rate annuities are more suitable for investors who need faster growth and want to invest more money than can be contributed to qualified plans like a 401K. Investors can pick and choose from a selection of options like mutual funds, which can hold a portfolio of bonds, stocks, money market instruments, etc. It's important to ensure that a variable annuity contract offers a minimum guaranteed rate of return, regardless of the performance of the underlying investments.
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