Wraparound Annuity

A Wraparound Annuity is a type of annuity that allows the investor (the holder of the annuity) control of the underlying investments in the annuity plan. An annuity is a tax-deferred contract sold my an insurance company that pays an income benefit on a regular basis for the life of the contract holder, the life of his or her spouse, or some other defined time period. The wraparound option gives the annuity holder the benefit of choosing the type of investments in the annuity.

An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income stream for retirees. Annuities are created and sold by financial institutions, which accept and invest funds from individuals and then, upon annuitization, issue a stream of payments at a later point in time. The period of time when an annuity is being funded and before payouts begin is referred to as the accumulation phase. Once payments commence, the contract is in the annuitization phase.

Because the income generated in a wraparound annuity plan is tax-deferred (that is, no taxes are paid until a withdrawal is made), the IRS no longer allows individuals to choose underlying investments for the purpose of evading taxes. The exception is when the annuity holder could not otherwise purchase a type of fund; in other words, the IRS does not allow individuals to shelter funds in the tax-deferred annuity if the underlying investments can be purchased through other means (without a tax deferral).

In a 1981 ruling, the IRS said purchasers of wraparound annuities were ''substantially identical'' to investors who bought mutual fund shares directly and whose income was taxed. Therefore, income these annuities generate would be subject to tax, and that has been the situation ever since.

Annuities can be structured generally as either fixed or variable. Fixed annuities provide regular periodic payments to the annuitant. Variable annuities allow the owner to receive greater future cash flows if investments of the annuity fund do well and smaller payments if its investments do poorly. This provides for a less stable cash flow than a fixed annuity, but allows the annuitant to reap the benefits of strong returns from their fund's investments.

Annuities are appropriate financial products for individuals seeking stable, guaranteed retirement income. Because the lump sum put into the annuity is illiquid and subject to withdrawal penalties, it is not recommended for younger individuals or for those with liquidity needs. Annuity holders cannot outlive their income stream, which hedges longevity risk. So long as the purchaser understands that he or she is trading a liquid lump sum for a guaranteed series of cash flows, the product is appropriate.