A tax-free annuity is an arrangement by which a customer gives a lump sum to a financial institution, after which the financial institution pays back money on an agreed basis until the customer's death. One type of annuity makes regular payments and is used as a pension provision. Another type acts more as a savings scheme, with the customer making withdrawals at times of their choice.
The benefits of a tax-free annuity depend very much on which type it is. The regular payments type is more common in Europe. The savings variant is more common in the United States today, although the regular payments system does exist.
In the regular payments system, the money a person has saved for retirement during his working life is used to buy an annuity at or sometime after he stops working. In return, he gets a regular payment back from the annuity provider until he dies. The amount of this payment usually depends on the person's age and gender, and may also be adjusted to take account health and lifestyle. For example, smokers may get a larger payment, as it is statistically more likely they will die earlier, at which point the payments cease.
In some countries, income that is put into savings with the intention of buying an annuity upon retirement is not taxed at the time. Usually in such countries, the laws say most or all of those savings must then be spent on an annuity upon retirement. The payments from the annuity are often taxed, meaning it can be misleading to describe such schemes as a tax-free annuity. Of course, the lack of taxation on the original income means there is more money going into the scheme, and thus considerably more money in the final savings fund to buy a better annuity.
In the second type of annuity, often known as a deferred annuity, the customer does not receive regular payments. Instead, her savings fund continues to grow and she can make lump sum withdrawals as and when she sees fit, although this will reduce the savings fund, of course. In most cases in the United States, the fund itself and the growth it achieves through investments is not taxed at the time, hence it is considered a tax-free annuity scheme. Instead, only the lump sum withdrawals are taxable. This means that a customer may control the amount of money she withdraws each year to minimize her tax payments, such as not taking enough money out to tip her total income for the year into a higher tax bracket.