An annuity is a series of payments under a contract made at regular intervals. You can purchase an annuity from life insurance companies and some mutual fund. Annuities come in two basic flavors: fixed and variable. Under a fixed annuity, you receive a definite amount for a specified period of time - for example, $400 a month for life. With a fixed annuity, your investment earns interest at a rate set by the insurance company, a rate that can change periodically in line with market interest rates. Under a variable annuity, the amount of the payments you receive may vary, depending on how your investments perform. A variable annuity gives you investment options much like a family of mutual funds. You have a choice of several funds - stock, bond, money-market, etc. - and your return depends on the success of the investments you choose.
Unlike bank CDs and mutual funds, however, an annuity contract serves as an impenetrable wrapper that keeps the tax collector's hands off your earnings. No tax is due until you pull funds out of the contract, presumably in retirement, either in a lump sum or by annuitizing the contract and having the company make payments to you for life.
Such tax-deferred growth gives funds invested in an annuity the same advantage as cash stashed in an individual retirement account. Unlike certain IRA contributions, amounts put into an annuity are not deductible.
If you cash in the annuity before retirement, you'll pay dearly. For one thing, most contracts impose surrender charges during the first several years. Any earnings pulled out of the annuity are taxable, and if you're under age 59 1/2, you'll be hit with a 10 percent penalty tax. But what portion of a withdrawal is earnings? That's easy, if you cash in the annuity and pull out all the funds. You are taxed, and possibly penalized, on the difference between your original investment and what you get.
It's trickier, though, if you pull out only part of the money. Before August 14, 1982, the IRS considers the first money pulled out of the annuity to be a tax-free return of your investment. Only after you have recovered your full investment is any further withdrawal taxed. For investments after August 13, 1982, however, the rule is turned around. The first money out is considered earnings - taxable and potentially subject to the 10 percent penalty.
Say, for example, that you now invest $10,000 in an annuity and its value grows to $25,000 in 10 years. If you were to cash in the contract, $15,000 would be taxed, and if you were under age 59 1/2, the 10 percent early-withdrawal penalty would apply to that portion. The other $10,000 would be a tax-free return of your original investment.
If you simply withdraw $10,000 from the contract, it will all be taxed and penalized, because the amount you withdrew ($10,000) is less than the amount earned by your investments ($15,000). If this investment had been made before August 14, 1982, however, that $10,000 withdrawal would be a nontaxable return of your investment.
The 10 percent penalty does not apply to payouts to taxpayers under age 59 1/2 who are disabled. Nor does it apply to any payment that is part of a series of substantially equal periodic payments based on your life expectancy. If you decide to annuitize a contract at age 50 (or any age) and receive substantially equal payments over the rest of your life, for example, you'd dodge the early-withdrawal penalty.
A key to shopping for an annuity is to watch that the fees charged by the insurance company don't devour a good portion of the tax breaks. Also realize this: Funds withdrawn from an annuity will be taxed in your top tax bracket, even if the source of the profits was capital gains on stock mutual funds owned inside the annuity. Critics complain that this means annuities convert tax-favored capital gains to heavily-taxed ordinary income. That's a real disadvantage because long-term capital gains are taxed at rates of five and 15 percent.
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