An annuity pertains to a number of payments, deposits or withdrawals, generally equal, that are transmitted at frequent intervals bearing compound interest. And they do not have to be annual as the name might imply, instead are given to any sequence of payments, identical in all instances. Irrespective of whether these payments are annual, semiannual, quarterly or monthly.
Basically, two practical phases for an annuity exist, and these entail one phase that sees a client depositing and accumulating funds into an account (otherwise referred to as the deferral phase). A second phase involves the client taking receipt of payments for a given period (known as the annuity or income phase).
In the course of income phase a service provider such as an insurance company can effect due income payments for a certain amount of time, or proceed until the death of the client (annuitant). In each case, annuitization on a lifetime basis almost always comes with a death benefit guarantee for a period of (say) ten years.
On the other hand, deferred annuities are those contracts that have a deferral phase and a mandatory annuity phase. Such annuity contracts can be tailored such that they only support an annuity phase, and are referred to as immediate annuities, although this may not always be the situation.
The distinctive characteristic of the immediate annuity relates to the fact that it serves a means for administering savings using a tax-deferred growth factor. A non-qualified immediate annuity faces a tax treatment that sees each payment comprising a tax free combination of a return of principal in addition to income (taxed at ordinary income rates). However, immediate annuities that are funded as an IRA are not included in the above tax arrangement.
It is also practical to customize the payments under an immediate annuity in such a way that they differ with the performance of a given set of investments, most often bond and equity mutual funds (variable immediate annuity contract).
Taxation and supervision
In general, the federal tax treatment of annuities is governed by the Internal Revenue Code. Variable annuities are governed by the Securities and Exchange Commission (SEC), while the sale of variable annuities is supervised by FINRA.
According to the Internal Revenue Code, the maturity of an annuity value in the course of the accumulation phase is tax-deferred, which applies to annuities possessed by individuals. This policy is largely attributed with the popularity of deferred annuities. The tax code also goes further to stipulate that benefits from annuity contracts do not necessarily have to be in the form of a fixed stream of payments (annuitization).
According to the tax regulation Section 1.72-5, whenever an annuity contract is acquired with after-tax funds, the contract bearer upon annuitization is in a position to recoup his basis pro-rata in the ratio of basis divided by the expected value (exclusion ratio). Following the recovery all of basis, then 100% of the payments are liable to ordinary income tax.