An excellent way to understand the nature of annuities is to examine the multitude of ways in which annuities can be classified. To illustrate, annuities can be classified according to whether payments are contingent on the continued survival of one or more individuals. A life annuity is a contract where continued payments after retirement are contingent on continued survival of the annuitant(s). In contrast, under an annuity certain contract, payments are made for a fixed period of time according to the terms of the contract and are not contingent on the continued survival of one or more annuitants. Most annuity contracts purchased today contain a life annuity feature. Life annuities can be further classified according to (1) the number of premium payments, (2) the time when benefit payments commence, (3) the number of lives (i.e., annuitants) covered, and (4) the units in which the benefits are expressed. Other classifications are also possible. As to the number of premium payments, single premium annuities are purchased with a lump sum payment (possibly representing a transfer of assets previously invested elsewhere); periodic premium annuities, usually permitting flexible premium payments that vary in amount, are the most popular annuities today. Regarding (2), immediate annuities (always purchased with a single premium) are contracts where the first benefit payment is received by the annuitant one month (usually) from the date the annuity was purchased. An immediate annuity might be purchased, for example, with the proceeds of a lump sum distribution from a qualified pension or profit sharing plan. Under deferred annuities, there is usually a period of many years between the date the annuity contract was purchased and the time when benefit payments commence. Deferred annuities may be purchased with a single premium or with periodic premiums. As to (3), annuity payments may be contingent on only one life--a single life annuity--or on more than one life. Under a joint and last survivor annuity, payments continue so long as either of two (or more) specific individuals is alive, although it is common for the benefit payment to be reduced when one of the annuitants dies. Joint and last survivor annuities are frequently purchased by married couples. Annuities can also be classified as fixed (dollar) annuities or variable annuities. Unlike the level periodic (e.g., monthly) benefits payable under a fixed annuity contract, periodic benefit payments under a variable annuity contract vary according to changes in the value of the contract's underlying asset base.

What is the federal income tax treatment accorded annuities?

The federal income tax treatment accorded annuities, governed by Section 72 of the Internal Revenue Code, has changed over the past 10-15 years. As a result, the specific income tax treatment may vary depending on when the annuity contract was purchased. Annuities purchased prior to August 14, 1982 enjoy somewhat more favorable income tax treatment than do annuities purchased after this date. In general, there is no current income taxation to the policy owner with respect to the interest credits applied to amounts invested in personally owned annuities. Taxation will occur when a portion or all of the cash value is withdrawn, when a loan is made against the cash value, when there is a partial or total surrender of the annuity, or when annuity liquidation begins. The taxable amount equals the excess, if any, of the cash value over the cost basis of the annuity contract. An annuity's cost basis, which is recovered tax free, generally consists of the premiums paid into the contract (less any dividends that were not previously taxed). Amounts subject to taxation are taxable as ordinary income and are not eligible for capital gains treatment. An additional 10 percent tax may apply to taxable annuity payments received after December 31, 1986 unless the annuity payments: (1) are made to an individual who is age 59 1/2 or older; (2) comprise a series of substantially equal payments (not less frequently than annually) over the lifetime of the annuitant or the joint lifetimes of the annuitant and designated beneficiary; (3) are made on the account of the death or disability of the annuitant; or (4) are attributable to investment in the contract prior to August 14, 1982. Other exceptions to the 10 percent "premature" distributions tax also exist. Because of the complexity of IRC Section 72, your tax adviser should be consulted when you need answers to specific questions concerning the federal income taxation of annuities.

How does the federal income tax treatment of annuities compare with the income tax treatment of life insurance?

In general, the tax treatment accorded life insurance is more favorable. For example, life insurance death proceeds are generally received income tax free by the beneficiary; in contrast, only the cost basis of an annuity contract is received income tax free at the annuitant's death. Further, policy loans against the cash value of a life insurance contract do not trigger taxable income to the policy owner, whereas a loan against the cash value of an annuity contract may create taxable income to the annuitant. Similar tax treatment applies to the "interest build-up" portions of life insurance and annuity cash values since current income taxation is avoided under both types of contracts. Because federal income taxation is a complex subject and because other taxes may apply (e.g., federal estate taxes), your tax adviser should be consulted with regard to all forms of taxation of annuity and life insurance products.