Annuity Plans: Definition, Types, and Tax Treatment
Annuity plans present a unique opportunity for individuals to have a steady source of income throughout their life. This aids in future financial planning as you can store a large amount of cash and defer paying taxes until later. In essence, annuity plans are designed to protect you from outliving your income.
What Is Annuity?
Most people consider an annuity an insurance plan rather than an investment vehicle. An annuity is a contract between an individual and an insurance company in which the individual will receive a regular payout for building a corpus through a lump sum or periodic payments. This can be considered more of an investment to be used as an income stream later in life.
Annuity means the insured will be assured of a regular income after a certain date. You can make a one-time lump sum payment or make regular payments for a specific period, and in return, you will receive regular payouts immediately or in the future.
How Do Annuity Plans Work?
Annuity plans come with an essential benefit of tax deferment. Annuity plans might be a good investment option if you wish to purchase a stream of payments over time and defer the tax payment by securing the payouts later.
After choosing an annuity plan from an insurance provider, you can invest through the lump-sum method or pay at regular intervals. You can select the tenure based on your needs and goals. Please note that tenure is one of the important factors that will decide your annuity payouts.
After receiving your investment, the insurance company re-invests your money in different securities or asset classes and uses the returns generated to pay you back.
As it will be mentioned in the annuity agreement, you will start receiving regular payouts after a specified date. You can choose to receive these payments monthly, quarterly, or yearly. In addition, you can choose from a fixed annuity plan which guarantees a specific return, or a variable annuity, the returns of which will depend on the performance of underlying assets of the annuity plan.
What Are the Different Types of Annuities?
Depending on the mode of payment and payout, annuity plans can be classified into the following six categories:
- Deferred Annuity
A deferred annuity is a type of plan where people will be investing regularly to build a corpus and once they retire they get a pension from this amount. These payments begin from a future date and not immediately.
- Fixed annuity
As the name suggests, fixed annuity plans ensure a fixed amount of regular income in the annuitized period. This plan is the most preferred one as it is more conservative and mostly invested in fixed income instruments. Even though there is little growth potential, this plan guarantees stable returns post-retirement.
- Variable annuity
Variable annuity plans are the opposite of fixed annuity plans. These plans invest in varieties of assets whose performances are based on market conditions. As a result, the payments can differ greatly from one to another. Market fluctuations affect the regular payouts, which is why many retirees do not prefer this plan. It holds potential for significant returns but also chances of minimal payouts.
- Periodic annuity
A period annuity works similarly to a regular pension plan. It makes payment to the annuitant at a specific point in time regularly. The only difference between this and a regular pension plan is that payments can also be made periodically from time to time towards the end of the 5th, 10th, and 15th years, irrespective of whether the earlier premium payments have been cleared.
- Immediate Annuity,
This type of annuity plan does not have an accumulation period, and the plan begins offering benefits from vesting age. This plan only works with lump sum investment. You start receiving payments either for a limited tenure or a lifetime.
- Lump sum annuity.
Although most annuity plans offer regular payouts to investors, some plans also provide the option of lump sum payouts. However, such an option usually comes with certain terms and conditions, such as a specified tenure or only a certain percentage of total investment available for lump sum withdrawal post maturity.
A good example could be the NPS (National Pension System) which offers only 60% of the total maturity amount for lump sum redemption post-retirement.
Tax Treatment of Annuities
Before you start investing in an annuity plan, you should make sure you understand its tax implications clearly. The tax regulations for annuities are easy to understand. Since these payments are made regularly and periodically, the Income Tax Department treats annuity payouts as regular income.
However, investments in annuity plans help you defer paying taxes. You can invest a lump sum in an annuity plan and pay taxes on the payouts after the annuitized period begins later. The payouts are taxed as per the applicable income tax slab of the taxpayer.
Annuity plans are eligible for tax deductions under Section 80C, Section 80CCC, and Section 80CCD. As per Section 80CCC of the IT Act, 1961, the lump-sum amount paid for an annuity plan is eligible for tax deductions of up to Rs. 1.5 lakh during a year. However, the deduction limit under all three sections has been clubbed together.
As annuity payments are taxable under the head ‘Salaries’, pensioners can claim a standard deduction of Rs. 50,000 or the amount of pension, whichever is less under section 16 of the IT Act.
By now, you must have got an idea of what annuity is and how it works. If you want a financially secured life post-retirement or want to establish a steady source of income that is tax-deferred, annuity plans can be a great option for you. You can manage your day-to-day expenses or even fulfill your long-term financial goals with proper planning and choice of investment.
Frequently Asked Questions about Annuity Plans
What are the terms and conditions for pre-maturity redemption of annuity plans?
There are certain terms and conditions for withdrawing your money before maturity. For example, policyholders are allowed to withdraw the amount if diagnosed with a critical illness. Also, the insurance provider pays back the deposit amount, wholly or partially, to the nominee after the demise of the policyholder. This depends on the policy.
Is there an age limit to investing in annuity plans?
There is usually no minimum age limit to invest in annuities. The maximum age limit is 100 years. However, this can vary from one insurance provider to another.
Do I need to file an ITR if my annuity is below Rs.2.5 lakh?
Any income below Rs.2.5 lakh is not taxable income, but you should file an ITR just for the record. This can sometimes be needed as your proof of employment.
Is there any downside to investing in annuity plans?
The decision to invest in annuity plans depends on the policyholder’s goals and needs. Annuity plans are low in terms of liquidity, and there can be withdrawal charges or penalties. However, they aid in tax deferment on lump-sum investments.
What factors do you need to consider before investing in an annuity?
Before investing in an annuity plan, you should consider the following factors:
1. Your long-term investment goals
2. Your post-retirement financial needs
3. Your other savings portfolio
4. The effect of inflation on your investment and ROI
5. Available alternate investment options