Annuities come in many different forms. There are immediate and deferred annuities, with both fixed and variable rates. However, whatever the type of annuity, all can be classified as either qualified or nonqualified annuities. And the distinction is easy.

Qualified annuities are used in connection with tax-advantaged retirement plans, such as defined benefit pension plans, Section 403(b) retirement plans (TSAs), or IRAs. Premiums for qualified annuities are generally paid with pretax dollars, as are any investments purchased for use in a qualified retirement plan.

By definition, any annuity not used to fund a tax-advantaged retirement plan or IRA is considered a nonqualified annuity. Contributions to nonqualified annuities are made with after-tax dollars--premiums are not deductible from gross income for income tax purposes. Abney Associates Team A financial advisory practice of Ameriprise Financial Services, Inc.

In essence, then, the products are the same. It is the placement in or out of a retirement plan (and the resulting tax treatment) that distinguishes one from the other.

QUALIFIED ANNUITIES

As noted, contributions to a qualified annuity are deductible to the individual or employer (and/or excludable from the income of the individual) at the time of contribution, as would be any tax-advantaged retirement plan investment. When an annuity is in a retirement plan, the rules of the plan govern all tax matters. Specifically, the special tax-deferral advantages of annuities, and the unique tax penalties and tax treatment of annuities at distribution, are superseded when used in a retirement plan by the tax rules governing all investments in such plans. Ameriprise Financial Abney Associates Team, It is for this reason that many financial advisors question the use of deferred annuities in retirement plans.

Note: Although it is true that the tax-deferral advantage of annuities is redundant in a qualified plan, annuity products may offer other features, such as a guaranteed death benefit, that may make them a viable investment option for a portion of a qualified plan portfolio.

NONQUALIFIED ANNUITIES

The rules for nonqualified annuities are different in many respects, because these products are purchased with after-tax money.

If the nonqualified annuity is partially or fully surrendered, the first dollars out are considered earnings, and all of the earnings are taxed as ordinary income rates. After all of the earnings have been distributed, the remaining portion that represents the original investment in the annuity is received tax free.

If payments are taken in the form of an annuity payout (i.e., a distribution taken out over a predetermined period of time), a portion of each payment is considered a return of the original investment and is excludable from gross income, and a portion is considered earnings and taxed as ordinary income tax rates. The percentages that are earnings and return of investment are based on the type of payout at the age of the recipient. Note, too, that distributions taken before age 59½ are subject to a 10 percent early withdrawal penalty tax on earnings.

Note: Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk, including the possibility of loss of principal. Variable annuities are sold by prospectus, which contains information about the variable annuity, including a description of applicable fees and charges. These include, but are not limited to, mortality and expense risk charges, administrative fees, and charges for optional benefits and riders. The prospectus can be obtained from the insurance company offering the variable annuity or from your financial professional. Read it carefully before you invest.

You know how important it is to plan for your retirement, but where do you begin? One of your first steps should be to estimate how much income you'll need to fund your retirement. That's not as easy as it sounds, because retirement planning is not an exact science. Your specific needs depend on your goals and many other factors.

USE YOUR CURRENT INCOME AS A STARTING POINT

It's common to discuss desired annual retirement income as a percentage of your current income. Depending on who you're talking to, that percentage could be anywhere from 60 to 90 percent, or even more. The appeal of this approach lies in its simplicity, and the fact that there's a fairly common-sense analysis underlying it: Your current income sustains your present lifestyle, so taking that income and reducing it by a specific percentage to reflect the fact that there will be certain expenses you'll no longer be liable for (e.g., payroll taxes) will, theoretically, allow you to sustain your current lifestyle.

The problem with this approach is that it doesn't account for your specific situation. If you intend to travel extensively in retirement, for example, you might easily need 100 percent (or more) of your current income to get by. It's fine to use a percentage of your current income as a benchmark, but it's worth going through all of your current expenses in detail, and really thinking about how those expenses will change over time as you transition into retirement.

PROJECT YOUR RETIREMENT EXPENSES

Your annual income during retirement should be enough (or more than enough) to meet your retirement expenses. That's why estimating those expenses is a big piece of the retirement planning puzzle. But you may have a hard time identifying all of your expenses and projecting how much you'll be spending in each area, especially if retirement is still far off. To help you get started, here are some common retirement expenses:

- Food and clothing

- Housing: Rent or mortgage payments, property taxes, homeowners insurance, property upkeep and repairs

- Utilities: Gas, electric, water, telephone, cable TV

- Transportation: Car payments, auto insurance, gas, maintenance and repairs, public transportation

- Insurance: Medical, dental, life, disability, long-term care

- Health-care costs not covered by insurance: Deductibles, co-payments, prescription drugs

- Taxes: Federal and state income tax, capital gains tax

- Debts: Personal loans, business loans, credit card payments

- Education: Children's or grandchildren's college expenses

- Gifts: Charitable and personal

- Savings and investments: Contributions to IRAs, annuities, and other investment accounts

- Recreation: Travel, dining out, hobbies, leisure activities

- Care for yourself, your parents, or others: Costs for a nursing home, home health aide, or other type of assisted living

- Miscellaneous: Personal grooming, pets, club memberships

Don't forget that the cost of living will go up over time. The average annual rate of inflation over the past 20 years has been approximately 2.4 percent. (Source: Consumer price index (CPI-U) data published by the U.S. Department of Labor, 2012.) And keep in mind that your retirement expenses may change from year to year. For example, you may pay off your home mortgage or your children's education early in retirement. Other expenses, such as health care and insurance, may increase as you age. To protect against these variables, build a comfortable cushion into your estimates (it's always best to be conservative). Finally, have a financial professional help you with your estimates to make sure they're as accurate and realistic as possible.

DECIDE WHEN YOU'LL RETIRE

To determine your total retirement needs, you can't just estimate how much annual income you need. You also have to estimate how long you'll be retired. Why? The longer your retirement, the more years of income you'll need to fund it. The length of your retirement will depend partly on when you plan to retire. This important decision typically revolves around your personal goals and financial situation. For example, you may see yourself retiring at 50 to get the most out of your retirement. Maybe a booming stock market or a generous early retirement package will make that possible. Although it's great to have the flexibility to choose when you'll retire, it's important to remember that retiring at 50 will end up costing you a lot more than retiring at 65.

ESTIMATE YOUR LIFE EXPECTANCY

The age at which you retire isn't the only factor that determines how long you'll be retired. The other important factor is your lifespan. We all hope to live to an old age, but a longer life means that you'll have even more years of retirement to fund. You may even run the risk of outliving your savings and other income sources. To guard against that risk, you'll need to estimate your life expectancy. You can use government statistics, life insurance tables, or a life expectancy calculator to get a reasonable estimate of how long you'll live. Experts base these estimates on your age, gender, race, health, lifestyle, occupation, and family history. But remember, these are just estimates. There's no way to predict how long you'll actually live, but with life expectancies on the rise, it's probably best to assume you'll live longer than you expect.

IDENTIFY YOUR SOURCES OF RETIREMENT INCOME

Once you have an idea of your retirement income needs, your next step is to assess how prepared you are to meet those needs. In other words, what sources of retirement income will be available to you? Your employer may offer a traditional pension that will pay you monthly benefits. In addition, you can likely count on Social Security to provide a portion of your retirement income. To get an estimate of your Social Security benefits, visit the Social Security Administration website (www.ssa.gov) and order a copy of your statement. Additional sources of retirement income may include a 401(k) or other retirement plan, IRAs, annuities, and other investments. The amount of income you receive from those sources will depend on the amount you invest, the rate of investment return, and other factors. Finally, if you plan to work during retirement, your job earnings will be another source of income.

MAKE UP ANY INCOME SHORTFALL

If you're lucky, your expected income sources will be more than enough to fund even a lengthy retirement. But what if it looks like you'll come up short? Don't panic--there are probably steps that you can take to bridge the gap. A financial professional can help you figure out the best ways to do that, but here are a few suggestions:

- Try to cut current expenses so you'll have more money to save for retirement

- Shift your assets to investments that have the potential to substantially outpace inflation (but keep in mind that investments that offer higher potential returns may involve greater risk of loss)

- Lower your expectations for retirement so you won't need as much money (no beach house on the Riviera, for example)

- Work part-time during retirement for extra income

- Consider delaying your retirement for a few years (or longer)

You may have heard that IRAs and employer-sponsored plans (e.g., 401(k)s) are the best ways to invest for retirement. That's true for many people, but what if you've maxed out your contributions to those accounts and want to save more? An annuity may be a good investment to look into.

GET THE LAY OF THE LAND

An annuity is a tax-deferred investment contract. The details on how it works vary, but here's the general idea. You invest your money (either a lump sum or a series of contributions) with a life insurance company that sells annuities (the annuity issuer). The period when you are funding the annuity is known as the accumulation phase. In exchange for your investment, the annuity issuer promises to make payments to you or a named beneficiary at some point in the future. The period when you are receiving payments from the annuity is known as the distribution phase. Chances are, you'll start receiving payments after you retire.

UNDERSTAND YOUR PAYOUT OPTIONS

Understanding your annuity payout options is very important. Keep in mind that payments are based on the claims-paying ability of the issuer. You want to be sure that the payments you receive will meet your income needs during retirement. Here are some of the most common payout options:

- You surrender the annuity and receive a lump-sum payment of all of the money you have accumulated.

- You receive payments from the annuity over a specific number of years, typically between 5 and 20. If you die before this "period certain" is up, your beneficiary will receive the remaining payments.

- You receive payments from the annuity for your entire lifetime. You can't outlive the payments (no matter how long you live), but there will typically be no survivor payments after you die.

- You combine a lifetime annuity with a period certain annuity. This means that you receive payments for the longer of your lifetime or the time period chosen. - Again, if you die before the period certain is up, your beneficiary will receive the remaining payments.

- You elect a joint and survivor annuity so that payments last for the combined life of you and another person, usually your spouse. When one of you dies, the survivor receives payments for the rest of his or her life.

- When you surrender the annuity for a lump sum, your tax bill on the investment earnings will be due all in one year. The other options on this list provide you with a guaranteed stream of income (subject to the claims-paying ability of the issuer). They're known as annuitization options because you've elected to spread payments over a period of years. Part of each payment is a return of your principal investment. The other part is taxable investment earnings. You typically receive payments at regular intervals throughout the year (usually monthly, but sometimes quarterly or yearly). The amount of each payment depends on the amount of your principal investment, the particular type of annuity, the length of the payout period, your age if payments for lifetime payments, and other factors.

CONSIDER THE PROS AND CONS

An annuity can often be a great addition to your retirement portfolio. Here are some reasons to consider investing in an annuity:

- Your investment earnings are tax deferred as long as they remain in the annuity. You don't pay income tax on those earnings until they are paid out to you.

- An annuity may be free from the claims of your creditors in some states.

- If you die with an annuity, the annuity's death benefit will pass to your beneficiary without having to go through probate.

- Your annuity can be a reliable source of retirement income, and you have some freedom to decide how you'll receive that income.

- You don't have to meet income tests or other criteria to invest in an annuity.

- You're not subject to an annual contribution limit, unlike IRAs and employer-sponsored plans. You can contribute as much or as little as you like in any given year.

- You're not required to start taking distributions from an annuity at age 70½ (the required minimum distribution age for IRAs and employer-sponsored plans). - You can typically postpone payments until you need the income.