Annuity (US financial products)

General

Annuity contracts in the United States are defined by the Internal Revenue Code and regulated by the individual states. Annuities have features of life insurance and investment products. In the US, annuity contracts are only allowed to be sold by insurance companies, although private annuity contracts may be arranged between donors to non-profits to reduce taxes. Insurance companies are regulated by the states, so contracts or options that may be available in some states may not be available in others. However, their tax treatment is dictated by the Internal Revenue Code. There are two types of annuity contracts: the immediate annuity, which guarantees payments for a period of years or the lifetime of an individual or couple, and the deferred annuity, which grows tax deferred until such time as the annuity contract is annuitized (converted into an immediate annuity) or cashed in (either in periodic withdrawals or in a lump sum).

Immediate Annuity

The term annuity in financial theory is most closely related to what is today called an immediate annuity. This is an insurance policy which in exchange for a sum of money, makes a series of payments. These payments may be either level or increasing periodic payments for a fixed term of years or until the ending of a life or two lives, or even whichever is longer.

The overarching characteristic of the immediate annuity is that it is a vehicle for distributing savings with a tax deferred growth factor. A common use for an immediate annuity might be to provide a pension income. In the US, the tax treatment of an immediate annuity is that every payment is a combination of a return of principal (not taxed) and income (taxed at normal income rates, not capital gain rates.) When a deferred annuity is annuitized, it works like an immediate annuity from that point on, but with a lower cost basis and thus more of the payment is taxed.

Deferred Annuity

The second usage for the term annuity came into being during the 1970s. This contract is more correctly referred to as a deferred annuity and is chiefly a vehicle for accumulating savings, and eventually distributing them either in the manner of an immediate annuity or as a lump-sum payment.

All varieties of deferred annuities owned by individuals have one thing in common: any increase in account values is not taxed until those gains are withdrawn. This is also known as tax-deferred growth.

A deferred annuity which grows by interest rate earnings alone is correctly called a fixed deferred annuity (FAs). A deferred annuity that permits allocations to stock or bond funds and for which the account value is not guaranteed to stay above the initial amount invested is correctly called a variable annuity (VAs).

A new category of deferred annuities has emerged in 1995, called equity indexed annuity (EIA). [2] Equity indexed annuities may have features of both deferred annuities just described. The insurance company typically guarantees a minimum return for EIA. An investor can still lose money if he or she cancels (or surrenders) the policy early, before a "break even" period. An over simplified EIA rate of return is equal to the "participation rate" multiplied by a target stock market index's performance excluding dividends. Interest rate caps, or administrative fee may be applicable.

There are two phases to a deferred annuity. The accumulation phase is the time between initial purchase and annuitization. The annuitization phase starts when the annuity is turned into a stream of payments. Before annuitization, the deferred annuity contract may allow the purchase of additional (premium) payments to the contract, increasing the contract's value. It should be noted that less than 1% of deferred annuinties are annuitized by annuitants.

Deferred annuities in the United States have an advantage that all capital gains and income are tax deferred until withdrawn. In theory, this allows more money to be put to work while the savings are accumulating, leading to higher returns. A disadvantage, however, is that when a variable annuity is withdrawn or inherited the interest/gains are treated as ordinary income and are taxed as such.

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