What is an annuity?
Key points
- An annuity is a contract with an insurance company designed to provide income, often during retirement.
- Annuities typically include an accumulation phase, followed by a payout phase that can last for a set period or a lifetime.
- Common types of annuities include fixed, variable and indexed annuities, each with different risk and return features.
- Annuities may offer benefits such as tax-deferred growth and predictable income, but they can also involve fees and limitations.
Annuities are financial products backed by insurance companies in which you pay a premium in exchange for income that can be paid for a fixed period or for the rest of your life, according to the Securities Exchange Commission (SEC). They can be used to supplement your retirement years.
How does an annuity work?
There are different types of annuities, but they all work similarly. To start, you pay money into the annuity through your insurance company by making either a single payment or a series of payments over time. This is called the contribution or premium. In return, the insurance company agrees to pay you income in the future.
Your annuity payment will start depending on the type of annuity you purchase. Immediate annuities can begin payments almost right away or between one to twelve months after a lump-sum deposit.
Deferred annuities are funded through multiple payments over time or a single, large lump-sum premium. These funds grow tax-deferred. Income payouts usually start at a future date you choose from two to 40 years in the future. Often, payouts begin at age 59½, or later, to avoid IRS penalties.
With any annuity you choose, you receive a series of payments over time. That income can last for a specific number of years or for the rest of your life.
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find an agentAre annuities insurance or investments?
Annuities are primarily long-term insurance product contracts designed to provide income in retirement. They are not considered investments like stocks. However, certain types of annuities with market exposure share investment-like features providing conservative tax-deferred growth and protection against market downturns, often having lower returns compared to stocks due to fees and caps on gains.
Types of annuities
Before choosing an annuity, it's important to understand the different types and how they might affect your financial picture. The main categories of annuities include:
| Type | How it grows | Risk-level |
|---|---|---|
| Fixed annuity | Guaranteed rate | Lower |
| Variable annuity | Market-based | Higher |
| Indexed annuity | Index-linked with floor | Medium |
Fixed annuities
A fixed annuity offers a specified interest rate during the accumulation phase, or the period during which your value is growing in the annuity. When you are ready for your stream of payments to begin, the value of your funds is turned into a steady stream of payments that provide a specified payment for either a certain period of time — say, 20 years — or for an indefinite period, such as your lifetime or the lifetime of you and your spouse, the SEC says.
Variable annuities
In a variable annuity, you direct funds accumulating in your annuity to investments of your choice that are offered by the insurance company — typically mutual funds, according to the SEC. Your income stream in retirement is dependent upon how well your investments performed during the annuity's accumulation phase, per the SEC.
Indexed annuities
An indexed annuity provides you with a return that is tied to a major stock market index, such as the Standard & Poor's 500 Composite Index, says the SEC. During the accumulation phase, your investment's rate of return reflects the performance of the selected index. However, these annuities typically also offer returns that are no less than a specified minimum, no matter the index's performance.
Pros and cons of annuities
Annuities can be an attractive retirement income choice for a number of reasons, including:
- Tax deferral: You don't pay taxes on the income and investment gains from your annuity until you begin receiving payments, says the Insurance Information Institute (III).
- Lifetime income stream: If you choose to receive annuity payments with a lifetime contingency, an annuity can provide an income stream for the duration of your retirement, explains the III.
- Death benefit: Should you pass away before you begin receiving payments, the person you name as a beneficiary will receive a specified payment, according to the SEC.
- Income protection: Depending upon your state of residence, annuities may offer protections that shield some or all your annuity's value from creditors.
Despite these benefits, annuities aren't the right choice for everyone, with potential disadvantages including:
- High costs: Some annuities may have significant fees (such as administrative fees, mortality and expense charges, or investment‑related fees), which can reduce your total payout.
- Limited liquidity: Annuities have a surrender period, typically lasting several years, where you may face penalties for early withdrawals.
- Complexity: Annuities have a reputation for being difficult to understand with varying contract types, riders, fee structures, and rules.
- Risk: While insurer failures are rare, annuities are not FDIC‑insured, so your money could be at risk if one occurs. State guaranty associations may offer limited protection.
For these reasons and more, an annuity may provide you and your family with increased financial security during retirement, while being less suitable for others. You may want to consult with your insurer or financial advisor to determine if annuities make sense for you.
Who are annuities best suited for?
Most people buy an annuity to get an income when they retire. They are often best suited for:
- Retirees and near retirees who want a reliable income stream throughout retirement.
- People concerned about outliving their savings, as certain annuities provide lifetime income.
- High-income earners who have already maxed out contributions to IRAs or 401(k)s.
- Those who don't need quick access to their funds, as annuities can come with penalties for early withdrawals.
Who may want to avoid annuities?
Annuities may not be suitable for everyone, particularly:
- Those under age 50 who may achieve greater growth potential by contributing to retirement accounts.
- Retirees who already have sufficient income from investments, pensions, Social Security, or other sources.
- Those who need flexible access to their funds, since early withdrawals can incur penalties.
- Individuals with a shorter life expectancy, since annuities are typically designed for long-term planning and those expecting to outlive their savings.
How are annuities taxed
Annuities are usually purchased with money that has already been taxed. Since the principal was funded with after‑tax dollars, you won't owe taxes on that amount again. However, any interest, dividends, or capital gains earned within the annuity grow tax‑deferred and are taxed as ordinary income when withdrawn.
If you have an annuity funded with pre-tax dollars (typically within tax‑advantaged retirement plans like Traditional IRAs, 401(k)s, or 403(b)s), your withdrawals are fully taxable as ordinary income because neither your contributions nor your earnings were taxed yet.