Types

• Two types of annuities are used for retirement planning. The first is a qualified annuity--an annuity purchased inside an individual retirement account (IRA). The second type of annuity is a non-qualified annuity. A non-qualified annuity is not part of any other government sponsored retirement plan. (Government-sponsored retirement plans include 401k plans, IRAs and 403b plans.) Government plans generally come with tax advantages that annuities do not have on their own, such as pretax contributions to the plan as with a 401k, or tax-free distributions from the plan, as with a Roth IRA.
  
  

Function

• You may make deposits into a qualified annuity on a pre-tax basis if the account is a traditional IRA. For non-qualified annuities, no tax deduction is allowed on contributions. Once contributions are made to the qualified annuity, the annuity then invests in fixed-interest or variable investments. Fixed-income investments include bonds and bond-like investments, which are often "embedded" into the contract. The insurance company managing the annuity invests the annuity's account into its general account that contains these fixed-income investments and then pays the fixed rate to the annuity contract. A variable investment is a mutual fund--a collection of stocks or bonds with a common investment objective. Investment returns fluctuate with the value of the mutual fund.
  
  

Significance

• The significance of receiving a tax deduction on contributions to a qualified annuity plan has to do with the amount of potential savings and total tax you pay. First, the potential savings amount inside of a qualified annuity is higher than with a non-qualified annuity since none of the contribution amount is taxed with the former. Second, the amount of tax you pay on your income while making the contributions is lower due to the fact that all contributions are pretax.
  
  

Benefits

• The benefit of getting a tax deduction on your annuity contributions is that you have more money to invest. This gives you a higher potential total account balance since any interest earned is on a higher principal dollar amount.
  
  

Disadvantages

• The disadvantage to receiving a tax deduction on your annuity contribution is that you will be forced to make mandatory withdrawals after age 70 1/2. The IRS publishes a required minimum distribution table that details the rate at which these withdrawals must be made. If your account balance is significant, it could negate the tax benefits you previously received on your contributions. This is because the income tax you pay will be based on a higher total dollar amount.