Earnings on Annuities

Annuities are designed to help retirees secure a stable lifetime income. An integral part of all defined-benefit plans, they can also be selected as a distribution option in defined-contribution plans and IRAs, at the participant's discretion. When annuities are purchased within IRAs or qualified plans, they receive all of the tax advantages of those plans.

The same is not true of so-called nonqualified annuities. For tax purposes, the law treats nonqualified annuities much like whole-life insurance: although taxes on premiums are not deferred (because they are paid with after-tax funds), taxes on earnings are deferred. Regular distributions (those promised by an annuity contract) are partially taxable, the taxable share being equal to the ratio of tax-deferred earnings to the value of the account. Irregular distributions (discretionary withdrawals) are treated differently; they are deemed to come from earnings first and thus in many instances are fully taxable.

Annuities can be classified according to their stability and thus can be either fixed or variable.

• Fixed annuities are the nonqualified equivalent of a defined-benefit plan--they guarantee a certain level of income that the annuitant cannot outlive.
  
  
• Variable annuities are invested in riskier assets, and the income they produce depends on how the investment performs.

As categorized by their timing, both fixed and variable annuities can be either immediate or deferred.

• People typically purchase immediate annuities when they retire by turning over their accumulated savings in return for a regular annuity payment. The desire for financial stability motivates most such purchases, since the arrangement has very limited tax advantages.
  
  
• People who purchase deferred annuities pay premiums (known as considerations) for a period of time before they retire. Those premiums are invested, and the purchasers then receive regular annuity payments when they retire. That arrangement offers limited tax advantages to people whose employment-based plans or IRAs are insufficient to cover their expected retirement needs.