For people searching for ways to save for retirement, aside from 401k plan or an IRA may opt to invest in an annuity. The term annuity provides all the benefits of a taxed-deferred growth as well as professional money management. It may be fixed, meaning, the investor will receive a guaranteed variable or a rate of return that introduces an investment risk element as well as the possibility of greater returns.
Basically, an annuity is a means or a financial instrument which is sold by many insurance companies where the purchaser of the annuity, better known as annuitant, offers regular payments to the prior company over a span of time referred to as accumulation period. This accumulation period can last for long even until the annuitant reaches his or her retirement age. If the said product is a variable annuity, the prior company invests the amount to a separate account that is composed of securities-based vehicles such as mutual funds. Once the accumulation period ends, such product annuitizes which means that the annuitant starts to receive investment plus the revenues or the returns in an installment basis.
The process that the annuity undergoes is called variable annuitization. Variable annutization is defined as the process of modifying the variable annuity starting from the accumulation phase to the payout phase.
In the accumulation period, the annuity forms accumulation units, which is described as measure of the overall performance of a separate account over a period of time. During annutization, the units or the accumulation units are now converted to annuity units that will figure out the amount of money needed for the installment payments. Since the figure of annuity units will not change, the value of the annuity unit may change according to the continuous performance of the separate account. These values may change in a monthly, quarterly, semi-annual and annual basis.
During the annuitization, the annuitant may also select an option for settlement that will dictate the span of time he or she wishes to receive the payments and how or if the payments will be dispersed continually to the beneficiaries upon his or her death. These options include receiving regular payments forever or receiving payments in specific period of time. He or she can also opt to leave the accumulation unit intact to generate interest while the accumulation fund is passed to the heirs upon his or her death.
Though variable annuitization is non-taxable in the accumulation phase, there are somehow some implications that the product has taxes once annuitized. The settlement option may play a significant role in finding out the taxation level. Since the variable annuities payout amount varies according to the performance of the separate account, the amount of the taxable income also change. Annuitants will receive a 1099 Form annually from the insurance provider that contains their tax liability. This will explain how the tax is calculated over a period of time. Hence, it should be settled according to the rules applied.