Structured Settlements:

Annuity

An annuity is an insurance contract. An annuity contract is created when an individual gives the insurance company money which may grow tax deferred and then can be distributed back to the owner in several ways.

Annuity contracts in the United States are defined by the Internal Revenue Code and regulated by the individual states. Annuities have features of life insurance and investment products. In the US, annuity contracts are only allowed to be sold by insurance companies, although private annuity contracts may be arranged between donors to non-profits to reduce taxes. Insurance companies are regulated by the states, so contracts or options that may be available in some states may not be available in others. However, their tax treatment is dictated by the Internal Revenue Code. There are two types of annuity contracts: the immediate annuity, which guarantees payments for a period of years or the lifetime of an individual or couple, and the deferred annuity, which grows tax deferred until such time as the annuity contract is annuitized (converted into an immediate annuity) or cashed in (either in periodic withdrawals or in a lump sum)

Immediate Annuity

The term annuity in financial theory is most closely related to what is today called an immediate annuity. This is an insurance policy which in exchange for a sum of money, makes a series of payments. These payments may be either level or increasing periodic payments for a fixed term of years or until the ending of a life or two lives, or even whichever is longer.

The overarching characteristic of the immediate annuity is that it is a vehicle for distributing savings with a tax deferred growth factor. A common use for an immediate annuity might be to provide a pension income. In the US, the tax treatment of an immediate annuity is that every payment is a combination of a return of principal (not taxed) and income (taxed at normal income rates, not capital gain rates.) When a deferred annuity is annuitized, it works like an immediate annuity from that point on, but with a lower cost basis and thus more of the payment is taxed.

Life annuities
A life or lifetime immediate annuity is used to provide an income for the life of the annuitant, i.e. a pension.

• Life Annuity

This annuity works somewhat like a loan that is made by the purchaser to the issuing company, who then pays back the original capital (which isn't taxed) with interest (which is taxed as income) to the annuitant on whose life the annuity is based. The assumed period of the loan is based on the life expectancy of the annuitant. In order to guarantee that the income continues for life, the insurance company relies on a concept called cross-subsidy. Because an annuity population can be expected to have a distribution of lifespans around the population's mean (average) age, those dying earlier will give up income to support those living longer who's money may otherwise run out.

A life annuity is most commonly used to transfer the risk that the annuitant will run out of money to the insurance company. Sometimes a portion of that money will purchase a life insurance policy which will guarantee that the heirs of the annuitant still receive an inheritance.

Deferred Annuity

The second usage for the term annuity came into being during the 1970s. This contract is more correctly referred to as a deferred annuity and is chiefly a vehicle for accumulating savings, and eventually distributing them either in the manner of an immediate annuity or as a lump-sum payment.

Read more about deferred annuity.

Taxation

In the U.S. Internal Revenue Code, the growth of the annuity value during the accumulation phase is tax deferred, that is, not subject to current income tax for annuities owned by individuals. The tax deferred status of deferred annuities has led to their common usage in the United States. Under the US tax code, the benefits from annuity contracts do not always have to be taken in the form of a fixed stream of payments (annuitization), and many of the contracts are bought primarily for the tax benefits rather than to get a fixed stream of income. If an annuity was used in a qualified pension plan or an IRA funding vehicle, then 100% of the annuity payment is taxable as current income upon distribution. If the annuity contract is purchased with after-tax dollars, then the policyholder upon annuitization recoves his basis pro-rata in the ratio of basis divided by the expected value according to the IRS regulations from Section 1.72-5. After the taxpayer has recovered all his basis, then 100% of the payments thereafter are subject to ordinary income tax.

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This article is licensed under the GNU Free Documentation License.
It uses material from the Wikipedia article "Annuity (US financial products)".