An annuity is a contract between you, the contract owner, and an insurance company for a fixed or increasing payment. The contract owner contributes funds to the annuity in exchange for an income stream for a specified number of years, for life, or for the joint lives of you and your spouse. Commencement of annuity payments (“annuitization”) can start immediately (“an immediate annuity”) or in the future (“a deferred annuity”).
The growth of the annuity value during the accumulation phase is tax deferred. If an annuity was purchased inside a qualified pension plan or IRA, then 100% of the annuity payment is taxable as ordinary income upon distribution. If the annuity contract is purchased with after-tax dollars, then the policyholder upon annuitization recovers his basis (that is, cost to purchase the annuity) pro-rata in the ratio of basis divided by the expected value. After the taxpayer has recovered all of his or her basis, then 100% of the payments thereafter are subject to ordinary income tax.
There are two basic types of annuities, fixed and variable annuities. With a fixed annuity, the insurance company guarantees a minimum return within the annuity, while also typically guaranteeing a minimum annuity benefit. The insurance company bears all risk of meeting these guarantees.
Alternatively, variable annuities have no guarantees as to return or annuity benefit. The contract owner invests the funds by selecting various sub-accounts, which operate similar to mutual funds. The contract owner bears all of the risk with variable annuities.