Types of Annuities
Annuities may be either immediate or deferred. An immediate annuity is an insurance
policy that, in exchange for the payment of an initial lump sum of money, makes a series
of payments to you that begin, as the name suggests, immediately. These payments
may be structured in a number of ways: they may periodically increase or they may
stay the same over the life of the annuity. The stream of payments may continue
for a fixed term of years or until the end of an annuitant's life.
One of the primary benefits of an immediate annuity is that it serves as a vehicle
for distributing savings with a tax deferred growth factor. As a result, one common
use for an immediate annuity is to provide a pension income. In the U.S., the tax
treatment of an immediate annuity is that every payment is a combination of a return
of principal (which is not taxed) and income (which is only taxed at normal income
rates, not at capital gain rates.)
A deferred annuity will take either a lump sum or periodic payments and hold that
money for a period of time, known as the accumulation period, before distributing
any payments. When you begin to receive payments, the annuity is
now annuitized. When a deferred annuity is annuitized, it works like an immediate
annuity from that point on, but with a lower cost basis, which means that more of
the payment is taxed. During the accumulation period, however, the annuitant is
not taxed for the growth in the account's value (which is known as tax-deferred
growth.)
There are two phases to a deferred annuity. The period between the time that the
annuitant makes the initial payment and the time that the stream of payments start
is called the accumulation phase. The period after the stream of payments starts
is the annuitization phase.
There are several types of deferred annuities. A fixed deferred annuity is a deferred
annuity that grows by interest rate earnings alone. A deferred annuity that is not
guaranteed to stay above the initial amount invested is a variable annuity. A variable
annuity allows the annuitant to make allocations to stock or bond funds and involves
a higher degree of risk than a fixed annuity.
An equity indexed annuity (EIA) has features of both fixed and variable deferred
annuities. EIAs involve more limited risk than variable annuities, because they
can only lose money on their investment if they cancel (or surrender) the policy
early, during the policy's stated "surrender" period. EIAs also involve more limited reward
than variable annuities, as they typically involve a cap on the amount of growth
the account can experience, regardless of how quickly the market grows.
Deferred annuities are advantageous in that all capital gains and income are tax-deferred
until withdrawn. However, when a variable annuity is withdrawn or inherited, the
interest and/or gains are treated as ordinary income and are taxed accordingly.
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