ANNUITY
A right to receive periodic payments, usually fixed
in size, for life or a term of years that is created by
a contract or other legal document.
The most common form of an annuity is
akin to a savings account. The annuitant, the
person who creates an annuity for his or her
own benefit, deposits a sum of money, the principal,
with an individual, business, or insurance
company to be invested so that the principal will
earn income at a certain percentage, usually
specified by the terms of the annuity. This
income is used by the company to pay the annuitant.
Each payment received by the annuitant,
sometimes called the primary beneficiary, represents
a partial return of the principal and a portion
of the income generated by its investment.
Such annuities are employed frequently to provide
a source of income to persons upon their
retirement. A group annuity contract supplies
periodic payments to a retired individual member
of a group of employees covered by their
employer’s master contract. A retirement annuity
is a policy paid to the annuitant after retirement.
If the annuitant dies prior to the
expiration of the annuity or wants to surrender
the policy, an amount specified in the terms of
the annuity is returned to the annuitant’s estate
or designated beneficiary.
Classification
Annuities are classified according to the
nature of the payment and the duration of time
for payment. A fixed annuity requires payment
in a specified amount to be made for the term of
the annuity regardless of economic changes due
to inflation or the fluctuation of the ventures in
which the principal is invested. A variable annuity
provides for payments that fluctuate in size
contingent upon the success of the investment
of the principal. Such variation offsets the effect
of inflation upon the annuitant. If, however, the
investment has fared poorly, the size of the payments
decreases.
A straight annuity is a contract by an insurance
company to make variable payments at
monthly or yearly intervals. A life or straight life
annuity is payable to an annuitant only during
the annuitant’s lifetime and ceases upon his or
her death. The size of the periodic payment is
usually fixed based upon actuarial charts that
project the expected life span of a person based
upon age and physical condition. This type of
annuity often contains provisions that promise
payment to be made to a secondary beneficiary,
named by the annuitant to receive benefits in
case of the annuitant’s death, or to the annuitant’s
heirs for a period of time even if the annuitant
has died before the expiration of the designated
period. A deferred annuity is one in which
payments start at a stipulated future date only if
the annuitant is alive at that time. Payment of
the INCOME TAX due on the income generated is
delayed until payments start. A deferred annuity
is used primarily by a person who does not want
to receive payments until he or she is in a lower
tax bracket, such as upon retirement.
A refund annuity, sometimes called a cash
refund annuity, is a policy that promises to pay a
set amount annually during the annuitant’s life.
In case the annuitant dies before receiving payments
for the full amount of the annuity, his or
her estate will receive a sum that is the difference
between the purchase price and the sum paid
during the annuitant’s lifetime.
A joint annuity is one that is payable to two
named persons but upon the death of one, the
annuity terminates. A joint and survivorship
annuity is a policy payable to the named annuitants
during their lives and continues for the
benefit of the surviving annuitant upon the
death of the other.
Tax Aspects
When an annuity is paid to an annuitant, he
or she receives a portion of the principal and
part of the return it has earned. For federal and
state income tax purposes, only the amount
attributable to the income generated by the
principal, not the principal itself, is considered
taxable income. The INTERNAL REVENUE CODE
provides an exclusion ratio to determine the
amount of taxable income paid to the annuitant.
Special tax rules apply to annuities that are qualified
employee retirement plans.
The annuity payments made to the estate of
a decedent might be subject to estate and gift tax
as an asset of the decedent’s gross estate. Federal
and state laws governing estate tax must be consulted
to determine the liability for such taxes.
CROSS-REFERENCES
Pension.
