What is an Annuity?
An annuity is a savings vehicle for the future. Think of an annuity like a reverse life insurance policy. You make a lump sum payment which earns interest. Generally this interest is higher than that of a Certificate of Deposit or savings account at a bank. Like a CD there is usually some type of penalty for taking money out early. When you need money an annuity can provide a steady stream of income for a period of time you chose such as a check every month or year. There are many different settlement options available.
Annuities can be an essential tool for securing your retirement and providing an income through your retirement years. There are many different kinds of annuities, it seems like every week, a new product released by a different financial institution. You can usually break them into a few categories.
Non-qualified annuities are purchased with after tax money and have their own tax implications. A portion of each annuity payout is considered earnings and taxed at ordinary income rates. There is no limit to the amount that a person can invest in a non-qualified plan and there are no required withdrawals.
A differed annuity simply means that you will choose to receive payments at a later date be it 1 year or 50 years later. You will deposit a lump sum, and later on when funds are needed you choose how and when your payments are sent. Because you will earn interest you will be taxed on the gains.
An immediate annuity means you will pay one lump some and immediately start receiving a payment that you choose. Because the money you paid in still earns interest a portion of your gain would taxable.
Tax Qualified Annuities: IRA and Roth IRA
Inherent in the name, tax qualified means there are tax incentives. Depending on the type of IRA you choose they can be pretax dollars on your contributions or tax breaks on the money you withdraw. It can be very confusing when you start talking about distributions, withdrawals, contributions.
Anyone who earns an income and is younger than 70 ½ can contribute to an IRA. Contributions are tax deferred, but when you take a withdrawal it is taxed as regular income. After Age 70 ½ you must begin taking your Required Minimum Distribution or RMD.
Roth IRAs have income restrictions and provide no tax breaks for money you put in. However earnings and withdrawals are generally tax free. Roth IRA’s also have no required annual withdrawals so your money can continue to grow.