Annuity Answers

An annuity is an investment in which you pay a premium in exchange for a revenue stream received after you retire. Although once the province of insurance companies, annuities are now offered by some brokerage houses as well. If used properly, an annuity provides tax deferral of interest and capital gains, and can contain the option of a guaranteed monthly income that you cannot outlive. It also can be a hedge against a Blue Chip IRA or 410(k) bashed by a bear market.

Annuities are very flexible financial vehicles. You can pay your premium all at once or you can pay it over time – it’s up to you. In addition, 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 attractive feature of annuities is that they are allowed to grow tax-deferred. Think of an annuity as an umbrella. When money is placed under the umbrella or annuity contract, it is treated differently as far as taxes go.

The money that you originally put in an annuity is referred to as a premium. Since you already have paid taxes on it, it never again will be subject to taxation. This assumes that you haven't purchased an annuity as part of a qualified retirement program such as an IRA, 401(k), TSA or 457 plan.

The money that you put into an annuity will be invested by the insurance company – you can decide to direct them how to invest it if you wish – and earn interest income, dividend income or capital gain distributions. These earnings, unlike money in a savings account, mutual fund or certificate of deposit are not taxed in the year in which they are earned. As a result, the earnings grow and compound tax-free until withdrawn.

The IRS eventually does collect taxes on the “earnings” of your annuity, of course. And when you withdraw money from your annuity, the earnings are withdrawn first.

The withdrawn earnings are subject to ordinary income taxes in they year in which they are withdrawn. Depending on your income tax rate, this can either be a tougher or lesser hit than the capital gains taxes you would pay had you instead invested the money in a Blue Chip mutual fund or Treasury bonds. Of course, you can also invest in an annuity that tracks Blue Chips, but you still will be paid out based on so-called index-linked interest rates and not the overall performance of the stock market.