Annuities are tax deferred savings contracts that are usually written by insurance companies.  The owner of the contract makes a payment or series of payments to the issuer or insurer and in return the insurance company promises to make a payment or series of payments to the contract owner in the future.  Although they have a reputation for having high fees, they can be advantageous in a variety of situations, including tax deferral as well as insuring against longevity risk of the annuitant and/or owner.  Unlike qualified plans such as 401K and 403B plans and IRAs, there is no annual limit to how much can be contributed to an annuity contract.

Tax deferral

Annuities allow the contract owner to defer taxes on gains inside the contract until their withdrawal.  When withdrawals are made, they are subject to first in first out (“FIFO”) reporting, in that the gains will be deemed to have been withdrawn first, and will thus be subject to taxes.  The contract owner will be subjected to a 10% penalty on withdrawals if the withdrawals are made prior to age 59 1/2.  Taxes on the gains upon withdrawal can be deferred and paid on a prorated basis by taking withdrawals on a periodic basis.

Management of longevity risk

Annuities provide a way to protect the contract owner against longevity risk.  As an example, consider an individual who, at retirement age, has a lump sum which needs to last through retirement.  If the retirement income strategy is to withdraw income only and preserve the principal, then there are no issues and an annuity may not be suitable or necessary.  However, if the retirement income strategy is to withdraw the lump sum gradually over many years, it is difficult to assess how much should be withdrawn as there is no way to know for how many years the withdrawals will be needed.  An annuity can protect against this uncertainty by making payment until the death of the annuitant.