Despite the best efforts of your insurance agent or banker, you may own an annuity and not know what it is.

So let's take time today to learn about this investment tool that is so often associated with retirement.

Annuities are investment accounts with life insurance policies attached to them.

Essentially, annuities are contracts between you and the insurance company. In exchange for your premium payments, the insurance company agrees to provide you with an income at some point in the future.

The insurance policy serves as a guarantee that if you die, your beneficiaries will still get the promised income. However, it is traditional life insurance with a face-value coverage amount.

Insurance agents, and bankers and brokers working with insurance companies, sell annuities, frequently to people as retirement saving and investing vehicles.

Annuities can either be qualified or nonqualified investments, according to Internal Revenue Service rules.

Qualified annuities are funded with pre-tax dollars. They are often found in 403(b) retirement savings plans available to schoolteachers and others working for government bodies or not-for-profit organizations. However, some 403(b) plans let participants invest in mutual funds.

After-tax income is used to fund nonqualified annuities.

Therefore, investing in a nonqualified annuity does not reduce your taxable income like contributing to an employer-sponsored 401(k) or 403(b) plan does. An individual retirement account may also provide you with an immediate tax break.

So it's best to fully fund an employer-sponsored retirement plan and an IRA and to consider other tax-savvy investment vehicles, such as tax-free municipal bonds, before buying a nonqualified annuity.

It grows tax-deferred

Once you invest in a nonqualified annuity, it grows tax-deferred, meaning the interest and dividends paid into the account won't be taxed until you withdraw the money.

However, you pay no tax on the principal when you take money out, since those dollars have already been taxed. When the growth in the account is taxed, it's taxed at your income tax rate at the time you withdraw the money.

Also, you can't pull money from an annuity without paying a 10 percent tax penalty until you reach age 59 1/2. However, exceptions are made for early withdrawals for medical expenses or disabilities and if you take the money out in equal installments over your lifetime.

Unlike IRAs, 401(k) or 403(b) plans, there are no limits on how much you can contribute to a nonqualified annuity and no requirements to withdraw money when you reach age 70 1/2.

Fixed and variable

There are two types of annuities: fixed and variable.

Fixed annuities pay a predetermined amount of money in regular installments. This is known as a fixed rate of return on your investment.

You can fund it by lump sum or periodic premium payments. But the insurance company invests that money for you, usually in government bonds, mortgage securities, corporate bonds and other fixed-income investments.

Variable annuities provide payouts based on the value of underlying mutual fund investments. Known as subaccounts, those mutual funds yield varying rates of return that can increase or decrease how much you collect.

The customer selects how the money is invested in those mutual funds. Typically, money can be transferred between funds tax-free. However, it is unusual to get a guaranteed minimum return on a variable annuity.

Fixed annuities tend to suit long-term savers, and variable annuities often are more appropriate for long-term investors.

When buying an annuity, pay close attention to the financial soundness of the insurance company selling it.

Check with rating services, such as Best and Moody's, to read assessments of the company by these how knowledgeable third-party reviewers.

Ask about the insurer's history of paying returns and how much it pays its sales force in fees and commissions.

Visit the Web sites of the National Association for Variable Annuities at to get more information.

Shannon Buggs invites comments and column ideas, but cannot offer specific financial advice about individual situations. E-mail her at or call 713-220-2000, access code 1003.