What is an Annuity?

Retirement Cash Flow

An annuity is a financial tool that will provide a succession of payments to a policyowner, or annuitant, in exchange for a single lump sum payment or series of payments to the insurer.  In other words, an annuitant pays an insurance company a certain amount which is then credited with a certain rate of interest, and this is how money grows in an annuity.

Annuities are interest bearing, tax deferred savings vehicles designed to provide future income in exchange for a lump sum or series of payments now.

During this growth period, or accumulation period, the rate of interest is not taxed, which allows for a greater accumulation of funds.  Once an annuitant is ready for the policy to start paying out (payout or annuity period), the annuity concludes its accumulation task and benefits are paid at specified periodic intervals.  These payments can either be paid over a certain amount of time, paid at a specific monetary amount per payment or act as a death benefit to an annuitant’s beneficiary.

During the annuity period, benefit payments are made to the annuitant that consists of both repayment of principal and earned interest.  While the principal repayment portion of an annuity payment is not taxed, any interest earned and paid to the annuitant is taxed as ordinary income.  In order to figure out the taxable portion of an annuity payment, an exclusion ratio is used to determine the ratio of taxable to nontaxable proceeds in an annuity payment.  The exclusion ration formula is simply the investment in the contract divided by the expected return.

Immediate vs. Deferred Annuities

An immediate annuity pays out immediately after the first payment period (depends on payment frequency: monthly, quarterly, semi-annual, or annual).  Used when a lump-sum amount is paid into the annuity and the annuitant wants to immediately spread it out over a period of time.

A deferred annuity delays payout to allow interest to compound over a period of time.  Again, a deferred annuity is not taxed so interest builds quicker to allow for a larger return for the annuitant.  A deferred annuity can be paid with a single premium or multiple premium installments and at a later date, paid out as income payments back to the annuitant (along with earned interest).

Annuities vs. Life Insurance

Although similar in concept to a life insurance contract, and often available through life insurance companies, an annuity, is quite the opposite.  Life insurance is concerned with creating an estate, and financially protecting an individual against death, where an annuity on the other hand is designed to protect an individual from outliving their financial resources, through the liquidation of such estate.