|What is an annuity?
An annuity is a contract issued by an insurance company and is usually referred to as an annuity policy or an annuity contract, What makes annuities different is the tax treatment given them by the IRS. Think of an annuity as an umbrella. When money is placed under the umbrella or annuity contract, it is treated differently as far as taxes go.
It is your original contribution or principal contribution. Since you have already paid taxes on it, it will never again be taxed again. The money you put in an annuity is referred to as a premium subject to taxation. This assumes that you have not purchased an annuity as part of a qualified retirement program such as an IRA, 401(K), TSA, or a 457 plan.
Withdrawing funds from an annuity
The money that you put into an annuity will earn interest or receive dividend income or capital gain distributions. These "earnings", unlike money in a savings account, mutual fund, certificate of deposit are not taxed in the year in which they are earned. Thus the "earnings" will continue to grow and compound tax free until withdrawn.
When you withdraw money from your annuity, the earnings, according to the IRS, are
withdrawn first. The "earnings" are subject to "ordinary income taxes" in the year in which thay are withdrawn. Keep in mind that capital gain distributions in a mutual fund are taxed at capital gains rates.
The IRS also has what it calls a "Premature Distributions". If you withdraw your earnings and your under the age of 59 1/2. Not only are your earnings tax at ordinary income tax rates, the IRS makes you pay a penalty of an additional 10% on the earnings that are taxed.The IRS eventually collects taxes on the "earnings" of your annuity.
However there are no penalties on distributions:
If the taxpayer becomes disabled.
A part of a series of substantially equal periodic payments (not less than annually) for the life (or life expectancy) of the taxpayer or joints lives (or joint expectancies) of the taxpayer and his or her designated beneficiary.
Made under a single premium immediate annuity with a starting date no later than one year from the annuity purchase date.
Made under certain annuities issued in connection with a structured settlement agreements.
Possibly Avoid Probate
If a premature death should occur, the accumulated funds within your annuity may be transferred to your named beneficiaries, avoiding the expense, delay, frustration and publicity of the probate process. Like most assets, the annuity is part of your taxable estate. Your heirs can generally chose to receive a lump sum payment, or a guaranteed monthly income.