An annuity contract is a personal finance vehicle sold by insurance companies. An annuity owner makes regular payments into the account for a certain period of time (or may contribute one large payment premium). The deposited funds grow at a fixed or variable rate. Any taxes on growth of the contributed funds are tax deferred until you start taking out the distributions. A retirement, or qualified, annuity allows you to make contributions with pre-tax dollars, which is its main differrence from a non-qualified annuity funded by after-tax dollars.
Qualified or Retirement Annuity
A qualified annuity is an investment vehicle that you can purchase as part of your IRA, 401(k) or 403(b) retirement plan. The premiums you contribute to the annuity are tax deductible. This means that you fund your account with pre-tax dollars, which also reduces your gross household income. However, keep in mind, that since this a retirement annuity, it has annual contribution limits (as set by your retirement plan) and early withdrawal penalties.
Contributions and Distributions
The payment premiums, or contributions, you make into your retirement annuity are not taxed. The funds are deposited and grow at a fixed or variable rate. All of the capital gains and dividends incurred during the growth period are tax deferred. The maximum annual amount of contribution is capped each year at a certain dollar figure. However, depending on your age you might be eligible to make additional catch-up contributions.
The distributions from your annuity are taxed at your then current income tax rate, which is lower at retirement.
A retirement annuity, similar to an IRA or 401(k), imposes penalties if you start withdrawing funds early. You cannot have any distributions from the annuity until you reach the age of 59-1/2. Otherwise, the IRS imposes a tax penalty of 10 percent and taxes the early withdrawn funds at your regular income tax rate. Your annuity plan can also charge an early withdrawal fee if you take money out before a certain time period, usually 5 or 7 years. However, if you have enough retirement income and don't need any funds from your annuity yet, you can leave them untouched until the age of 70-1/2. You must start taking distributions on or before April 1st of the year you are turning 70 1/2.
Types of Retirement Annuities
Your annuity can be either fixed or variable. With a fixed annuity your contributions grow at a fixed rate, similar to a savings account or a CD, and you receive fixed payments at retirement. A variable annuity grows funds at a variable rate and is subject to market risk, similar to mutual funds or stocks. The payments out of a variable annuity vary depending on the account performance. Your risk tolerance will determine which investment option to choose.
An annuity can also be a fixed period or lifetime when referring to the distributions. A fixed-period annuity pays funds back to you for a set period of time. If you die during that period, your heirs, or beneficiaries, will continue receiving distributions until the time period is over. A lifetime annuity stops making payments at your death, regardles how long it has been since the distributions begin. However, your annuity plan might offer an option to continue payments to your spouse until his/her death.