Annuity Definition: Types & Tax Treatment

What Is an Annuity?

An annuity is a contract between you and an insurance company in which you make a lump-sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future.

Understanding Annuities

The goal of an annuity is to provide a steady stream of income, typically during retirement. Funds accrue on a tax deferred basis and—like 401(k) contributions—can only be withdrawn without penalty after age 59½.

Many aspects of an annuity can be tailored to the specific needs of the buyer. In addition to choosing between a lump-sum payment or a series of payments to the insurer, you can choose when you want to annuitize your contributions—that is, start receiving payments. An annuity that begins paying out immediately is referred to as an immediate annuity, while one that starts at a predetermined date in the future is called a deferred annuity.

The duration of the disbursements can also vary. You can choose to receive payments for a specific period of time, such as 25 years, or for the rest of your life. Of course, securing a lifetime of payments can lower the amount of each check, but it helps ensure that you don’t outlive your assets, which is one of the main selling points of annuities.

Types of Annuities

Annuities come in three main varieties: Fixed, variable, and indexed. Each type has its own level of risk and payout potential. For any of these, it is often structured as a deferred annuity.

Fixed

Fixed annuities pay out a guaranteed amount. This type of annuity comes in two different styles—fixed immediate annuities, which pay a fixed rate right now, and fixed deferred annuities, which pay you later. The downside of this predictability is a relatively modest annual return, generally slightly higher than a certificate of deposit (CD) from a bank.

Variable

Variable annuities provide an opportunity for a potentially higher return, accompanied by greater risk. In this case, you pick from a menu of mutual funds that go into your personal “sub-account.” Here, your payments in retirement are based on the performance of investments in your sub-account.

Indexed

Indexed annuities fall somewhere in between when it comes to risk and potential reward. You receive a guaranteed minimum payout, although a portion of your return is tied to the performance of a market index, such as the S&P 500.

Despite their potential for greater earnings, variable and indexed annuities are often criticized for their relative complexity and their fees. Many annuitants, for example, have to pay steep surrender charges if they need to withdraw their money within the first few years of the contract.

Tax Treatment of Annuities

An important feature to consider with any annuity is its tax treatment. While the balance grows on a tax deferred basis, the disbursements you receive are subject to income tax. The funds you receive are taxed at your regular income tax rates. By contrast, mutual funds that you hold for over a year are taxed at the long-term capital gains rate, which is generally lower.

Additionally, unlike a traditional 401(k) account, the money you contribute to an annuity doesn’t reduce your taxable income. For this reason, experts often recommend that you consider buying an annuity only after you’ve contributed the maximum to your pre-tax retirement accounts for the year.