An estimated $200 billion has flowed into annuities in 2012, more than double the level in 2011. When it comes to retirement savings, the attraction is clear: tax-deferred returns with no limits on new investment, guaranteed income for life in many cases, as well as death benefits. Given paltry interest rates and a volatile stock market, it’s no wonder retirement-minded people are turning to annuities.

Easy Entry

An annuity is a contract between you and a large insurance company (10 insurers have 70 percent of the annuity business). You invest a lump sum or make a series of payments. In return, the insurer agrees to make periodic payments back to you, immediately or in the future. The payments can last for a number of years, or your entire lifetime, or the lifetime of you and your spouse.

There are three types of annuities.

Fixed: The insurer pays a specified interest rate on your investment, as well as a specified payout per dollar in your account.

Indexed: Investment returns are based on an index, such as the S&P 500, and there’s a minimum guaranteed payout, regardless of index performance.

Variable: You choose from a range of investment options, typically mutual funds. So your rate of return and payout depend on your fund selection.

Tax Man Cometh

You don’t pay taxes while the annuity is in the accumulation phase. But when withdrawals start, all appreciation— both income and capital gains—are taxed as ordinary income.

For tax purposes, annuities are divided into two categories.

Qualified annuities are funded with pre-tax dollars. These are usually offered at the workplace as part of a retirement-savings program, with money deducted from pay and put straight into the annuity.

Non-qualified annuities are bought with after-tax income on an individual basis.

Taxes on withdrawals vary, depending on whether the annuity is qualified. With qualified annuities, all payouts are taxed as income.

With non-qualified annuities, the tax situation is more complicated. If you opt to take an annuitized income stream, a percentage of each payment will be taxed. For example, say you put $100,000 in a non-qualified annuity that will pay you $1,500 a month for 10 years. Your gain is $80,000, or 44 percent of the total payout. So 44 percent of the $18,000 you receive annually (around $7,920) would be taxed as income. The rest is not taxed, since it’s a return of your previously taxed principal.

Alternatively, many annuities allow you to make periodic withdrawals, instead of annuitizing. In such cases, the tax code assumes you’re receiving the gains first. So you’re taxed on the entire amount of each withdrawal, until you’ve received the total of your investment gains. After that, the payouts are not taxed because they’re a return of principal.

Let’s assume you bought an annuity for $100,000, and it’s now worth $180,000. If you withdraw the full amount at once, you’d owe taxes on $80,000. But if you make 18 withdrawals at $10,000 each, you’d be taxed on just the first eight payments, not the remaining 10.

Both qualified and non-qualified annuities charge early withdrawal penalties if you make withdrawals before age 59 ½. Always consult an accountant or tax specialist for advice regarding your specific situation.