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In the United States an annuity contract is created when an insured party,
usually an individual, pays a life insurance company a single premium that will
later be distributed back to the insured party over time. Annuity contracts
traditionally provide a guaranteed distribution of income over time, such as via
fixed payments, until the death of the person or persons named in the contract
or until a final date, whichever comes first.1 However, the majority of modern
annuity customers use annuities only to accumulate funds free of income and
capital gains taxes and to later take lump-sum withdrawals without using the
guaranteed-income-for-life feature.
Although annuities have only existed in
their present form for a few decades, the idea of paying out a stream of income
to an individual or family dates back to the Roman Empire. The Latin word
"annua" meant annual stipends and during the reign of the emperors the word
signified a contract that made annual payments. Individuals would make a single
large payment into the annua and then receive an annual payment each year until
death, or for a specified period of time. The Roman speculator and jurist Gnaeus
Domitius Annius Ulpianus is cited as one of the earliest dealers of these
annuities, and he is also credited with creating the very first actuarial life
table. Roman soldiers were paid annuities as a form of compensation for military
service. During the Middle Ages, annuities were used by feudal lords and kings
to help cover the heavy costs of their constant wars and conflicts with each
other. At this time, annuities were offered in the form of a tontine, or a large
pool of cash from which payments were made to investors.2
One of the early
recorded uses of annuities in the United States was by the Presbyterian Church
back in 1720. The purpose was to provide a secure retirement to aging ministers
and their families, and was later expanded to assist widows and orphans. In
1912, Pennsylvania Company Insurance was among the first to begin offering
annuities to the general public in the United States. Annuities have continued
to grow in popularity and prove their value over and over as individuals,
organizations and businesses look for secure ways to guarantee retirement
income. Some prominent figures who are noted for their use of annuities include:
Benjamin Franklin assisting the cities of Boston and Philadelphia; Babe Ruth
avoiding losses during the great depression, OJ Simpson protecting his income
from lawsuits and creditors. Ben Bernanke in 2006 disclosed that his major
financial assets are two annuities.3
The term "annuity," as used 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, guarantees
that the issuer will make 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. It is also possible
to structure the payments under an immediate annuity so that they vary with the
performance of a specified set of investments, usually bond and equity mutual
funds. Such a contract is called a variable immediate annuity. See also life
annuity, below.
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 U.S., the tax treatment of a non-qualified immediate annuity is that every
payment is a combination of a return of principal (which part is not taxed) and
income (which is taxed at ordinary income rates, not capital gain rates).
Immediate annuities funded as an IRA do not have any tax advantages, but
typically the distribution satisfies the IRS RMD requirement and may satisfy the
RMD requirement for other IRA accounts of the owner (see IRS Sec 1.401(a)(9)-6.)
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.
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