An annuity is an investment agreement that insurance companies provide to customers. Under the contract, you make a cash deposit with the insurer. In exchange, you start receiving distributions — or annuity income — on the date the contract specifies. Generally, this type of investment offers tax-free gains until you begin to receive payments. Your earnings are then taxed at the income tax rate, not as capital gains.
Types of Annuity Income
Annuities come in three forms: variable, fixed and indexed. The type of agreement you have with the insurer determines the kind of income you receive. Variable annuities invest your capital in mutual funds or a similar fund that does not guarantee a return on your investment. Thus, your earnings vary. A fixed annuity promises a guaranteed minimum interest rate until you start making withdrawals. Your fixed-annuity income is also a specific dollar amount with no or nominal variation. The fixed payments may occur in perpetuity or over a set length of time. The earnings of an indexed annuity fluctuate according to how well or poorly the investment index to which it is linked performs. To protect you from major loss, an indexed-annuity agreement stipulates a minimum income the insurance will pay you.
Annuity income is taxed based on whether you pay for the contract with after- or pre-tax money, according to Kimberly Lankford, contributing personal finance editor, on Kiplinger.com. If you use your IRA or 401(k) funds to invest in the annuity, you will owe income taxes on the principal and earnings. On the other hand, if you buy the annuity with your after-tax salary, for example, you will pay taxes on the earned interest only. The IRS treats your first distributions as the withdrawal of your gains. Thus, you start paying taxes as you begin to receive payments. Your annuity income becomes tax-free after you are paid all the earnings your principal balance earned.
Annuities grow tax-free, even the variable option, if you allow sufficient time for it to mature. To give your fund a boost, you may also make unlimited contributions to it, raising its principal balance and the interest it earns. Besides, you may withdraw the funds as a lump sum or in installments. Just remember your tax liability from the single payment will be due to the IRS all at once.
Annuities are subject to high and multiple fees, including surrender fees. If you withdraw your annuity fund within the first few years of opening the account, it is subject to a surrender fee of 7 to 20 percent of the balance. Annual maintenance fees reach 3 percent. And if you set up your annuity as a retirement account, you will pay a 10 percent penalty on top of income taxes if you take distributions before the age of 59 ½.
Emma Watkins writes on finance, fitness and gardening. Her articles and essays have appeared in "Writer's Digest," "The Writer," "From House to Home," "Big Apple Parent" and other online and print venues. Watkins holds a Master of Arts in psychology.