What are the Risks and Tax Consequences associated with Annuities?
Risks
Regardless of where you purchase an annuity, even at a bank, the insurance company- and not the bank-stands behind the policy. Although banks are federally insured, insurance companies are not. If the insurance company should fail, your deposits can be frozen for years.
An investor should consider the financial strength of the insurance company that writes annuity contracts. Major insolvencies have occurred since the conspicuous collapse of the Executive Life Insurance Company in 1991.
Insurance company defaults are governed by state law. The laws are, however, broadly similar in most states. Annuity contracts are protected against insurance company insolvency up to a specific limit, often $100,000.
This protection is not insurance and is not provided by a government agency. It is provided by an entity called the state Guaranty Association. When an insolvency occurs, the Guaranty Association steps in to protect annuity holders and decides what to do on a case-by-case basis. Sometimes the contracts will be taken over and fulfilled by a solvent insurance company.
The state Guaranty Association is not a government agency but states usually require insurance companies to belong to it as a condition of being licensed to do business.
Taxation
In U.S. Internal Revenue Code, the growth of an annuity value during the accumulation phase is tax deferred, that is, not subject to current income tax for annuities owned by individuals. The tax deferred status of deferred annuities has led to their common usage in the United States. Under the U.S. tax code, the benefits from annuity contracts do not always have to be taken in the form of a fixed stream of payments (annuitization), and many of annuity contracts are bought primarily for the tax benefits rather than to receive a fixed stream of income. If an annuity is used in a qualified pension plan or an IRA funding vehicle, then 100% of the annuity payment is taxable as current income upon distribution (because the taxpayer has no tax basis in any of the money in the annuity). If the annuity contract is purchased with after tax dollars, then the contract holder upon annuitization recovers his basis. After the taxpayer has recovered all of his basis, then 100% of the payments thereafter are subject to ordinary income tax.
Also, any withdrawals before an investor reaches the age of fifty-nine are generally subject to a 10% tax penalty in addition to any gain being taxed as ordinary income.

Thought for the Week
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Those who loved you will remember.
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