An annuity contract is a type of insurance contract that functions like an investment account and pays the annuitant monthly payment until the annuitant dies. There are two major types of annuity contracts: immediate and deferred. Any growth within an annuity contract is tax deferred. Annuity contracts can also be set up to pay monthly income for a set period of time, for the lifespan of more than one person, or for the lifespan of the annuitant plus several years after the annuitant's death. Another form of annuity contract that is becoming popular is the charitable annuity, explained below.
Immediate annuity contracts are annuities that are purchased with a lump sum of cash and then begin making monthly payments to the annuitant within one year. As with all other annuity contracts, the annuity will pay the income for the rest of the annuitant's life. These annuity contracts are typically purchased by retirees cashing out a pension plan who don't want to have to worry about outliving their money.
Deferred annuity contracts don't pay the annuitant income immediately. The two phases of a deferred annuity are the savings phase and the income phase. Just like it sounds, during the savings phase the annuitant pays into the annuity contract for a period of time (often many years) while the annuity contract increases in value. Once the annuitant reaches retirement, he can either take a lump sum distribution of the total amount of the annuity contract or he can begin the income phase for the rest of his life.
Deferred annuity contracts can either be fixed or variable. Fixed rate annuity contracts pay a predetermined annual yield for the life of the contract. Variable annuity contracts pay a variable rate according to the performance of whatever underlying index they are required to follow. Equity indexed annuity contracts are popular because they provide some of the returns of the stock market with none of the risk.
Finally, charitable annuity contracts enable investors to donate a lump sum to charity and be guaranteed annual income for life. They also provide a tax deduction at the time of purchase. The way they work is that the annuitant receives annual income until he dies and whatever is left in the annuity contract is donated to the specified charity.
Annuity contracts can be purchased at any age. When the annuity contract enters the income phase, the monthly income is determined by the annuitant's life expectancy based on life insurance company actuarial tables. If the annuitant dies before attaining his life expectancy, the insurance company gets to keep whatever is left in the annuity contract.
Many annuity contracts pay a bonus for a set period of time. In the case of deferred annuity contracts, the time period can be as long as five years and the bonus can be up to five percent. In other words, any funds invested in the annuity contract during the first five years immediately receive up to a five percent bonus on top of the annual return.
Like many other retirement vehicles, annuity contracts are subject to age requirements established by the IRS. The penalty for withdrawal of annuity funds prior to age 59 and a half is 10 percent of the withdrawal amount and any gains taxed at ordinary income rates.
Some annuity contracts carry egregious surrender charges. The surrender charge period of an annuity contract can be as long as 15 years as well. In other words, if an investor changes his mind about the annuity contract during the surrender charge period, he will have to pay heavy fees to cash out.