An annuity is a contract between you and an insurance company designed to provide a retirement income. In exchange for a current premium, your insurer agrees to pay you a future stream of income. Annuities are very flexible. You can pay your premium all at once or pay it over time. You can specify when you would like to begin receiving the income from your annuity. You can start immediately or you can let your annuity accumulate.
One of the attractive features of annuities is that they can grow tax deferred. You do not have to pay taxes on the growth of your annuity until withdrawn. There may be a 10 percent penalty on amounts withdrawn prior to the age of 59 in addition to income tax. Surrender charges may also apply in the early years of the policy.
With an immediate annuity payments begin a month after you have paid a lump sum premium. This makes them a good source of supplementary income for retirees. Immediate annuities provide only some tax deferral. Only the interest portion of each payment is considered taxable income. The rest of each payment is considered a return of your principal. Taxes on the earnings of the annuity are spread over the payout period, which means you pay fewer taxes in the early years.
With a deferred annuity you let your premiums accumulate before you start the payout period. Deferred annuities give you the option of paying fixed or flexible premiums and you can pay them all at once or over time. The earnings of the annuity are not taxed until they are withdrawn. You decide when to start receiving income from your annuity.
Unlike the fixed annuities (immediate and deferred annuities) a variable annuity is an annuity contract that provides variable returns. You have control over how your premiums are invested. When you pay your premium, you choose from a variety of different investment sub accounts, such as stock, bond or fixed-interest options. Your premium is then allocated among these portfolios. Unlike traditional annuities which pay a fixed interest, the value of your variable annuity is based on the performance of the subaccounts you select. These sub accounts will fluctuate in value and may be worth more or less than the original cost when redeemed.
Variable annuities provide the dual advantages of investment flexibility and the potential for lower current taxes. The taxes on all interest, dividends and capital gains are deferred until withdrawals are made. When you decide to receive income from your annuity, you can choose a lump sum, a fixed or variable payout. The earnings of the annuity will be subject to income taxes when you begin receiving income.
Variable annuities are ideal for using investment strategies such as asset allocation and dollar cost averaging. They are flexible and can be tailored to suit the needs and objectives of most investors. Variable annuities have management fees and other expenses though which are higher than those of fixed annuities.