If you can figure out a definition for "annuity" you will have no problem understanding what happens when an IRA holds an annuity contract. But it's not so easy to agree on a definition of annuity.
Historically an "annuity" means a regular level cash payment paid periodically from one party (the issuer) to another (the annuitant). That payment is not merely the "income" from an asset, it is the asset.
Social Security checks are classic annuity payments: The retiree receives a check for the same amount each month (subject to occasional increases for cost-of-living adjustments) for his or her lifetime. The payments stop when the annuitant dies; there is no underlying asset for the annuitant to leave to his or her beneficiary.
The Social Security-type "true" annuity is called an "immediate" annuity in the tax code, to distinguish it from the other type frequently held inside IRAs, the "deferred" annuity. A deferred annuity issued by an insurance company is sort of a collection of mutual funds held inside an annuity "wrapper." The contract provides terms on which the owner may someday convert it into a true annuity. Typically the contract provides a deadline (the latest date or age when such conversion may occur); allows the annuitant to withdraw funds from the contract prior to such "annuitization"; and provides various minimum-value guarantees, such as a guarantee that distributions to the contract holder and his or her beneficiaries will at least be equal to what the contract holder paid into the contract, plus (in some cases) a minimum guaranteed rate of return, regardless of the performance of the underlying mutual fund investments.
A deferred annuity, even if held outside an IRA, is a tax-deferral vehicle as well as an investment vehicle: The investment gains occurring inside the contract are generally not subject to income tax until distributed to the owner or his beneficiary.
Both immediate and deferred annuities can be held in an IRA. Some deride the idea of holding a deferred annuity in an IRA because it seems like buying a tax shelter inside a tax shelter. So, why would someone do that? Usually because he already has the money inside his IRA and is looking for something to invest it in--and the guaranteed minimum returns of today's deferred annuity contracts can appear attractive to that IRA owner.
Although both kinds of annuity contracts can be held in an IRA, they have very different consequences under the minimum distribution rules.
A deferred annuity is treated almost like any other asset held inside an IRA: Its value is included in the prior year-end account balance of the IRA on which the following year's required minimum distribution is computed. There is one special valuation rule for these contracts, requiring that the value of the minimum guarantees be included in the "fair market value" of the contract under certain circumstances.
An immediate annuity is treated entirely differently. Such "true" annuities have their own set of minimum distribution rules. Those special rules dictate what type of true annuity may legally be purchased inside an IRA. The menu of available options includes most of the standard annuities people purchase, such as monthly payments for the life of the IRA owner, or joint lives of the IRA owner and his or her spouse or other beneficiary, or for a fixed term of years, with or without a minimum guaranteed term. The regulations permit all of these, provided the regular payments begin no later than approximately age 70 1/2, the payments are level (non-increasing) (though cost-of-living adjustments or small percentage increases are permitted), and any term or minimum guaranteed term does not extend past approximately the IRA owner's age 96.