Annuities are financial products that are designed by life insurance companies. The contract itself is an insurance policy. Annuities can actually be traced back to Roman times when citizens would make a payment and receive an annual stipend in return.

Over time, these products become more refined and complex. Governments began using them for anything from fund-raising vehicles to pensions. Today, however, annuities are part of a regulatory nightmare. While the regulation is not as obvious as with other retirement arrangements, annuities are burdened by government regulations as to how the policy must function, when money can be withdrawn without penalties and guidelines as to how money is to be paid out to retirees (in regards to pensions).

Regarded as "non-qualified retirement accounts", some annuities have become long-term savings accounts. These annuities are referred to as "savings annuities" or "deferred annuities."

Fortunately, annuities remain less regulated than other retirement vehicles in some respects. There are no arbitrary contribution limits. You can fund an annuity account with as much money as you can manage to find.

Annuities are not taxed on the cash build-up inside of the policy, but the nature of that tax exemption is somewhat different from government-created tax shelters. Instead of being subject to whim, annuities are private contracts. The fact that there is an exemption from taxation is primarily the result of insurance companies fighting to keep the government from imposing regulations on private insurance contracts, rather than the IRS designing a retirement plan around a "tax loophole." This may naturally limit the damage a government can do to the policy (assuming it respects contract law). If insurers continue to be successful in preventing their contracts from being taxed, you'll keep a tax exemption for your annuity. Even if the law changes, the common course of action is to "grandfather" existing contracts, preventing new laws from modifying or affecting old contracts. Still, the government is technically capable of anything so while grandfathered contracts has been the common practice, there's not guarantee that new laws won't affect old contracts.

Annuities provide income insurance. The money in the annuity is held for the benefit of the policyholder by an insurance company. Money is invested in fixed interest investments or mutual funds. This money may then be converted to a monthly payment (called an "immediate annuity), which will last for the policyholder's lifetime or for a set number of years, depending on the particular arrangement agreed upon by both the insurance company and the policyholder. These payments, which are guaranteed by the insurance company, serve to "insure" the policyholder's retirement income. Regardless of what happens to the savings after retirement, the insurer promises to pay the stated income to the policyholder.

The IRS does place some arbitrary rules on the annuity contract, however. They are generally restricted to withdrawals from deferred annuities. Withdrawals from annuities may not be made prior to age 59 1/2, similar to the age limit imposed on other retirement plans. Like early withdrawals from other retirement plans, there is a 10 percent penalty on early withdrawals from annuities. There is, of course, an exemption to this rule, contained under IRS rule 72(q), which allows early withdrawals similar to the withdrawals allowed under IRS 72(t) for IRAs.

There is no required minimum distribution at age 70 1/2, as there is with traditional 401(k)s, Roth 401(k)s, and traditional IRAs, but all investment gains in the annuity are subject to income tax when they are withdrawn.

Even though annuity gains are taxed when income is received, the contract provides some measure of control over how those taxes are paid. When converting the annuity's savings to payments, you forever lose access to the savings. But, most of the payment you receive is treated as a return of your investment principal, which is not taxable. Only a small amount, perhaps only 5 percent or less, is considered investment gain, which is taxable at ordinary income tax rates. The ratio of investment principal to investment gain is often referred to as the "exclusion ratio".

This payment scheme differs significantly from keeping the deferred annuity and simply making withdrawals. Making withdrawals from a deferred annuity requires that you remove all of your investment gain from the account prior to removing any of your investment principal. If you have a lot of investment gain, you'll be paying a lot of income tax upfront.

Those are the essential points to remember about annuities, but the IRS has given us some reading material if we want to know more.

This post is part of a series on retirement plans. Want to read more? Here's the rest in the series:

Arbitrary Retirement Plan Rules, Part 1: 401k Plans

Arbitrary Retirement Plan Rules, Part 2: IRAs

Arbitrary Retirement Plan Rules, Part 3: Annuities

Arbitrary Retirement Plan Rules, Part 4: Employer Pension Plans

Arbitrary Retirement Plan Rules, Part 5: A Solution