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An annuity is a contract issued by an insurance company that can act as a retirement vehicle for the annuitant. An annuity provides a tax deferral of interest and capital gains and may even provide a guaranteed monthly income for life if the funds are annuitized. Using an annuity as a retirement vehicle is desirable because the money accumulating in an annuity grows on a tax deferred basis.

There are generally two parts to an annuity, the accumulation phase and the distribution phase. However, it is not mandatory that the annuitant exercise the annuitization option and enter into the distribution phase. If desired, the annuitant can just cash out the annuity after the accumulation phase.

The Accumulation Phase

During the accumulation phase, the annuity terms may vary depending on the type of annuity that is selected. Annuities may be purchased with a lump sum payment or with recurring periodic payments. Annuity income may also begin immediately or be deferred until later. The safety of principle and interest may also vary depending on the type of risk involved with the chosen annuity type. The following are a few things to know about the accumulation phase.

Understanding Tax Deferral

Annuity funds grow on a tax deferred basis during the accumulation phase, but this does not mean tax free. When the money is ultimately paid out, income taxes must be paid on most annuities. If the annuity is part of a qualified retirement plan, income taxes are paid on the money as it is withdrawn.

Early Withdrawals

There may be a surrender charge for early withdrawals from an annuity, though there may be an allowable withdrawal amount that is exempt from fees. If money is withdrawn before the annuitant turns 59, it is considered a premature distribution and is subject to a 10% IRS penalty in addition to fees. In the case of premature death, however, funds are transferred to a named beneficiary.

Distribution Phase

During the distribution phase, the annuitant can withdraw money or annuitize. If the annuitant opts to withdraw money, the money can either be taken out in a lump sum or can be systematically withdrawn. If the owner opts to annuitize, an annuity pay out plan is purchased.

Annuity Pay Out Plans work as follows:

  • In Fixed and Indexed plans the owner purchases a guaranteed monthly income that will be paid until death
  • In a Variable annuity plan, the owner has the option to transfer all or part of income to available sub-accounts and produce income based on the performance of those accounts
  • In Life Only plans, periodic payments that are decided upon at the time of purchase are paid to the owner for the duration of their life
  • In Life with 10 Years Certain plans, payments are made to the owner for at least 10 years or as long as the owner lives. If the owner dies within 10 years, payments are made to a beneficiary
  • In Life with 20 Years Certain plans, payments are made to the owner for at least 20 years or as long as the owner lives. Payments are made to a beneficiary if the owner dies before 20 years.

The material presented on our web site may contain concepts that have legal, accounting and tax implications. It is not intended to provide legal, accounting or tax advice, you may wish to consult a competent attorney, tax advisor, or accountant.

Note: Any reference to the word guarantee is based on the claims paying ability of the underlying insurance company.

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