An annuity is an insurance product designed to guarantee you an income for the rest of your life or for a set period of time. Annuities are assets often used by pension plans to secure the payment of benefits for eligible employees. But even a private annuity used by an individual is an asset.
There are two basic types of annuities that may be purchased. A fixed annuity guarantees the payment of interest on savings you deposit into the annuity. A variable annuity offers no such guarantee. Instead returns on the deposited savings vary or fluctuate with the underlying assets (i.e., mutual funds) that generate the returns on the insurance policy.
Fixed annuities are guaranteed, because the underlying assets are bonds or bond-like investments. These investments are income-producing assets and pay a fixed rate of return by the nature of the investment. Variable annuities, on the other hand, use mutual funds. Mutual funds are a collection of stocks and sometimes bonds that produce variable rates of return. Even bond mutual funds fluctuate in their returns, because the bonds inside of the mutual fund often are actively traded, thus producing fluctuating returns in the fund.
The benefit of an annuity is that it is an asset that may receive special legal protections by your state's government. Some states protect annuities from judgments obtained by creditors in a lawsuit. The proceeds of the annuity are considered a non-qualified retirement account. Non-qualified refers to the requirements set forth by the IRS for an account to receive certain tax privileges. Even though annuities do not receive all the tax benefits of an IRA, and are thus considered "non-qualified," the annuity does receive some tax benefits. All annuities are exempt from taxation while your savings are left inside the annuity. This allows you to build larger retirement savings than would otherwise be possible, assuming all other investment factors remain equal.
The disadvantage of annuities is that they are not fully protected from a legal standpoint. The IRS may seize annuity proceeds to satisfy a tax debt. Likewise, not all states offer the same legal protections to annuities. Your state may protect all of the annuity's value from creditors, or it may only protect a fraction of the proceeds. If you are sued and your annuity can be taken from you, in whole or in part, you will have to rebuild any savings that were in your annuity. This, in turn, may result in you not being able to retire when you had planned.