What is Annuities? Types, Features, Tax Treatment

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What is Annuities?

An annuity is defined as a contract that provides periodic payments for a certain period of time, such as a number of years or for life. The payments may start on a specified date and may be payable for a certain number of years or for the duration of an individual’s life. The individual whose life governs the duration of the payments is called the annuitant.

Annuity is also a risk sharing plan just like insurance. In this, the annuitant pays the premium whereas the insurer pays the given amount periodically, depending on the annuity plans and conditions. Thus, annuity can be defined as a contract in which an annuitant makes lump sum or periodic payments to the insurer and in return, the insurer agrees to give the annuitant a lump sum payment in the future or regular guaranteed payments either on a monthly or yearly basis.

Definitions of Annuities

Let us learn some definitions of annuities:

According to W.A. Dinsdale, Annuity may be defined as the payment of amounts periodically during lifetime of the annuitant in consideration of the payment of an agreed sum to insurance company.

According to Mayerson, The life annuity is a device that liquidates the annuitant’s capital over the life time, paying him an income comparing both interest on his money and portion of principal.

Annuity as a contract is sold by life insurance companies. It provides fixed or variable payments to the annuitant, immediately or at a future date.

Individuals generally purchase an annuity to accumulate funds so that they can be a source of income after retirement. Annuity is required for maintaining an upgraded life standard after retirement and meet- ing the medical needs in old age.

The basic function of a life annuity is that of liquidating a principal sum, regardless of its accumulation. Life annuity mainly provides cov- er against the risk of outliving an individual’s income. It may comprise the liquidation of a sum derived from an individual’s savings (includ- ing the annuity itself or the cash value of life insurance policies) or the liquidation of life insurance death benefits in the form of a life income to beneficiary of the policy.

Types of Annuities

There are generally three types of annuities:

Immediate Annuity

This type of annuity is purchased with a single premium and is also called a straight life annuity. Payment for the annuity begins after three months, six months or one year after the purchase of the annuity. The payment can be in form of monthly, quarterly or yearly instalments. The annuity ceases on the death of the annuitant.

Immediate annuity certain

This type of annuity is similar to immediate annuity with the difference that this annuity plan continues after the death of the annuitant. After the death of the annuitant, within a certain period, the remainder of the payments are paid to the beneficiary.

Deferred annuity

In this type of annuity plan, the annuity payments are not paid immediately but are instead scheduled for a payment sometime in the future. The benefits under deferred annuity become payable only after some specific period, called the deferment period.

Fixed annuities

In fixed annuities, insurance companies usually guarantee the principal amount and a minimum rate of interest. Thus, there is stability of income in fixed annuities. The growth of the annuity’s value and/or the benefits paid may be fixed at a certain amount or by an interest rate, or they may grow by a specified formula and this growth does not depend directly on the performance of the investments the insurance company makes to support the annuity.

Variable annuities

In these annuities, the income payment varies as per the movement in stocks. Money in a variable annuity is invested in a fund, such as a mutual fund. The fund has a specific investment objective, and the value of an individual’s money in a variable annuity and the amount of money to be paid out to the individual is estimated by the investment performance (net of expenses) of that fund.

Fixed period vs lifetime annuities

A fixed period annuity pays an income for a certain period of time, such as ten years. The amount paid does not depend on the age (or continued life) of the individual who purchases the annuity; instead, the payment depends on the amount paid into the annuity, the duration of the payout period, and (in case of a fixed annuity) an interest rate that the insurance company believes it can support for the length of the payout period.

A lifetime annuity provides income for the remaining life of an individual. The amount paid depends on the age of the individual, the amount paid into the annuity, and (in case of a fixed annuity) an interest rate that the insurance company believes it can support for the duration of the expected payout period.

In case of a “pure” lifetime annuity, the payments are not carried out when the individual dies, even if it is for a very short time after they began. Thus, several annuity buyers are uncomfortable at this possibility which leads them to add a guaranteed period, essentially a fixed period annuity, to their lifetime annuity. With this combination, if an individual dies before the fixed period ends, the income continues to the individual’s beneficiaries until the end of that period.

Qualified vs non-qualified annuities

Qualified annuities are purchased with pre-tax money. They are used to invest and disburse money in a tax-favoured retirement plan. These annuities offer attractive tax benefits as they help to reduce taxable income and accumulate tax-deferred earnings.

A non-qualified annuity is an annuity that is purchased from after-tax money. Payments from a non-qualified annuity are not subject to income tax.

Single premium vs flexible premium annuities

A single premium annuity is a type of annuity that is funded by a single payment. This payment might be invested for growth for a long duration of time, called a single premium deferred annuity or invested for a short duration of time, after which payout starts, called a single premium immediate annuity. Single premium annuities are mostly funded by rollovers or from the sale of an appreciated asset.

A flexible premium annuity is a type of annuity that is intended to be funded by a series of payments. These annuities are only deferred annuities, that is, they are structured to have a significant period of payments into the annuity along with investment growth before any money is withdrawn from them.

Features of Annuities

Irrespective of the classification or type of annuity, there are features that remain common to all of them. In this section, we shall summarise these features:

Suitable for future estate planning

In most situations, proceeds from an annuity are passed directly to the beneficiary or estate of an annuitant without any delay or additional expenses. The procedure is simple so it saves the beneficiary from the legal complications, expenses and unnecessary delays.

Tax deferral

Earnings on a deferred annuity account are taxed only upon withdrawal, offering the annuity with a tax benefit. This type of annuity also offers a death benefit, so that the beneficiary of the annuity is guaranteed the principal and the investment earnings.

No limit to contribution

An annuitant can contribute as much as he/she wants in order to avail the tax benefits of tax-deferral or variable accounts. The contribution can be made up to the maximum limit offered by the insurer.

Flexible payment options

Many annuity schemes offer the choice to decide when to begin receiving payments. Usually one of the following options can be selected:

  • Lump sum distribution, which is a one-time payment
  • Periodic distributions, which allow the contract holder to take money when required ‰
  • Systematic distributions in which a fixed or variable amount is disbursed at regular intervals
  • Annuitisation, which guarantees fixed or variable payments for the rest of life period.

Tax control

An annuity is typically composed of two financial components:

  • Principal
  • Earnings

If an annuity plan is purchased with an after-tax amount, only the earnings would be eligible for tax deductions.

In case of plans where payments are of the following modes: lump sum, periodic, and systematic distributions, when the payments commence, firstly the taxable earnings component is exhausted followed by the principal. In cases of annuitisation, principal and interest form the component of each payment, hence distributing tax liability evenly among payments.

However, annuities may not always be the only option for tax control. In case of premature death of the contract holder, for any annuity that is accumulating, all deferred taxes on its growth will become due, thus reducing the annuity’s value.

Easy to start and maintain

The process of purchasing and renewing annuities is a simple one which requires an application to be filled and signed by the proposer along with the fee.

Miscellaneous features

Annuities do not offset social security benefits such as bond, certificate of deposit and other investment income.

Annuities are easy to buy and have an option of a “free look period” where a person can cancel the contract if it does not suit the requirements.

Previous annuities can be replaced with newer fixed annuity without any tax consequence.

Tax Treatment of Annuities

Government of India (GOI) provides many tax provisions as well as benefits for the insured. The tax rebates and exemptions under insurance plans are applicable under Section 88, 80D, 80 DDA, 80 CCC (I) and 10 D(D) of the Income Tax Act.

Let us discuss the tax treatment of annuities as follows:

Tax Treatment under Section 88 in Case of Annuities Deductions under 80C of the Income Tax Act are allowed on savings up to `Rs 100,000 in a financial year with the following conditions:

  • Any sum paid by on individual in order to effect or to keep in force a contract for deferred annuity, on his own life or the life of his spouse or any child, provided such contract does not contain a provision for the exercise by the insured of an option to receive a cash payment in lieu of the payment of annuity.

  • Any sum deducted in accordance with the conditions of salary from the salary payable by or on behalf of the government to any individual for the purpose of securing to him a deferred annuity or making provision for his spouse or children. The sum deducted should not exceed 1/5th of his salary.

  • Payment made by an individual to effect or keep in force a contract for notified annuity plan of insurance company.

  • Any contribution by an individual to a notified pension fund set up by
    • any mutual fund referred in Section 10(23D)
    • the administrator or the specified company as referred to in Section 2 of the Unit Trust of India

Tax Implication on Receipt of Annuity

The following is the tax implication on receipt of annuity:

Amount received from pension fund is taxable: The amount standing to the credit of the assesse in pension account, for which a deduction has already been claimed by him, and accretions in such account, shall be taxed as income in the year in which such amounts are received by the assesse or his nominee on closure of the account or his opting out of the said scheme or on receipt of pension from annuity plan. Annuity which is received from insurance policies is taxable as income from other sources.

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