An annuity is tax-deferred investment sold by insurance companies to help investors supplement other retirement income. There are two annuity structures: an immediate annuity and a deferred annuity. Of the deferred annuities, an investor may purchase a fixed or variable annuity. Each of these options affects principal in different ways.
In an annuity, because the contract is with an insurance company, the owner of the annuity pays premiums. These premiums may be paid in a lump sum, in periodic payments or regular contributions. An annuity can be either qualified as in an employer sponsored plan or nonqualified. In qualified annuities, the principal is pretax dollars and will grow deferred, taxed upon liquidation. In nonqualified annuities, the principal is the base that earnings are generated on, but as after-tax premiums will not be taxed upon distribution.
In an immediate annuity, the owner pays one lump sum premium to obtain an immediate income stream that lasts either for the remainder of the lifetime of the annuitant or for a specified number of years. When you buy an immediate annuity, you are not able to cancel the contract or adjust it at any period of time. This means that the principal paid into the contract is absorbed by the insurance company to pay operating expenses and invest to support the income indefinitely.
Deferred annuities generate cash value over the course of the annuity contract. When the owner pays premiums, the principal value increases as does the cash value. With fixed annuities, the principal amount is often guaranteed such that if you liquidate the entire annuity prior to the contract terms, any penalties or fees will only affect earnings, not principal. Variable annuities do not offer this same guarantee. When owners invest premiums, the money is placed in mutual fund subaccounts. These accounts are not guaranteed, thus the principal fluctuates with the mutual fund changes.
Most annuities name beneficiaries on the contract where benefits are paid to the beneficiaries upon the death of the annuitant. With immediate annuities, the contract must have a specific rider that offers a death benefit to pay the beneficiaries the remaining balance of an annuity if a designated number of payments were not made during the annuitant's life--meaning he died prior to realizing the full benefit. These policies still offer a lifetime income stream but may not pay as much as those that don't. Fixed annuities guarantee that the entire cash value is paid to the beneficiaries, which includes the principal and earnings. Variable annuities pay beneficiaries the value of the annuity based on the fluctuations. If the principal has increased, the beneficiary will receive the principal plus earnings. If the value went down, the beneficiaries receive what remains.
Because there are so many types of annuities, there are misconceptions about the investment product. It is important for investors to discuss specific annuity contract terms with a financial adviser or tax adviser to properly understand how principal is affected.