An annuity is a contract between you and an insurance company: you pay money in (either as a lump sum or over time), and the insurer pays you a stream of income later, often for the rest of your life. Annuities are primarily used as retirement income tools, designed to solve one specific problem: the risk of outliving your savings. How much you earn, how much risk you take on, and how your payouts work all depend on the type of annuity you choose.
How Annuities Work in Two Phases
Every annuity has two distinct phases. During the accumulation phase, your money grows inside the contract on a tax-deferred basis, meaning you don’t owe income tax on the gains each year. This phase can last decades if you buy an annuity in your 30s or 40s, or it can be skipped entirely if you purchase what’s called an immediate annuity, which starts paying you right away.
The second phase is the payout phase (also called annuitization). At a point you choose, the insurance company begins converting your account balance into periodic payments. You can typically elect monthly, quarterly, or annual payments. The size of each payment depends on your balance, your age, current interest rates, and which payout structure you select.
Fixed, Variable, and Indexed Annuities
The biggest decision when buying an annuity is how your money grows during the accumulation phase. Each type carries a different level of investment risk.
A fixed annuity guarantees both the interest rate and eventual payout. The insurer sets a rate, often locking it in for several years before adjusting it periodically. Your balance isn’t affected by stock market swings, which makes this the most predictable option. In exchange for that certainty, returns tend to be modest.
A variable annuity lets you invest in a menu of stock, bond, and money market funds called subaccounts. Your balance rises and falls with the performance of those funds. There is no guarantee you’ll earn a return, and you can lose money. The upside is greater growth potential over long time horizons.
An indexed annuity sits between the two. It offers a minimum guaranteed interest rate plus additional interest tied to the performance of a market index like the S&P 500. Your principal is generally protected, but the market-linked portion of your return is not guaranteed. Many indexed annuities also cap how much you can earn in a strong market year, so you participate in gains only up to a ceiling.
A newer variation called a registered index-linked annuity (RILA) also ties returns to a market index but handles losses differently. You choose either a “buffer,” where the insurer absorbs the first portion of any loss (say, the first 10%), or a “floor,” where you absorb losses up to a set percentage and the insurer covers anything beyond that. In return for accepting some downside exposure, RILAs typically offer higher caps on potential gains than traditional indexed annuities.
Payout Structures
When you begin receiving income, you pick a payout structure that determines how long payments last and what happens if you die during the payout period.
- Straight life (pure annuity): You receive payments for as long as you live. When you die, payments stop entirely, with nothing going to heirs. Because the insurer takes on the full longevity risk, this option provides the highest payment amount per dollar invested.
- Period certain: The insurer guarantees payments for a set number of years, commonly 10 or 20. If you die before the period ends, your beneficiary receives the remaining payments. Payments are smaller than straight life because the insurer is guaranteeing a minimum payout window.
- Joint and survivor: Payments continue until the last covered person dies, making this popular among married couples. Some versions reduce the payment amount after the first person dies, while others keep it the same.
Many contracts also let you combine features. A “life with period certain” option, for example, pays you for life but guarantees at least 10 or 20 years of payments to a beneficiary if you die early.
Fees and Costs
Annuities tend to carry higher fees than other retirement investments, and those fees vary significantly by type. Total annual expenses can run 3% or more of your account value per year, particularly for variable annuities. Here are the main costs to watch for:
Surrender charges apply if you withdraw money or cancel the contract early. These charges commonly range from 5% to 25% of the amount withdrawn and are highest in the first few years. The average surrender charge period lasts about seven years, with the penalty gradually declining each year until it disappears.
Mortality and expense (M&E) fees are charged by the insurance company to cover the cost of guarantees built into the contract, such as a death benefit. Variable annuities almost always include M&E fees. Fixed annuities typically don’t list them separately because the insurer builds its costs into the interest rate it offers you.
Administrative fees cover ongoing servicing costs like account statements and record-keeping. These are often a flat annual charge or a small percentage of your balance. Investment management fees on the underlying subaccounts apply to variable annuities on top of all the other charges.
Tax Rules and Early Withdrawal Penalties
Annuity earnings grow tax-deferred, but you owe ordinary income tax on the gains when you take money out. How much of each payment is taxable depends on whether you funded the annuity with pre-tax or after-tax dollars.
If you bought the annuity with after-tax money (a “non-qualified” annuity), only the earnings portion of each payment is taxable. The portion that represents a return of the money you originally put in comes back to you tax-free. If the annuity was funded with pre-tax dollars through a workplace retirement plan or traditional IRA (a “qualified” annuity), the entire payment is generally taxable as ordinary income because you never paid tax on the contributions.
Withdrawals taken before age 59½ typically trigger an additional 10% tax penalty on the taxable portion. The IRS waives this penalty in limited situations: if you become totally and permanently disabled, if you’re certified as terminally ill, if you set up a series of substantially equal periodic payments after leaving your job, or if the payment is made after the contract holder’s death.
How Annuities Are Protected
Unlike bank deposits, annuities are not insured by the FDIC or any federal agency. Your payments are backed by the financial strength of the insurance company that issued the contract, which is why the insurer’s creditworthiness matters. Rating agencies like AM Best, S&P, and Moody’s publish financial strength grades for insurance companies, and checking those ratings before you buy is one of the most practical steps you can take.
If an insurance company does become insolvent, your state’s insurance guaranty association steps in to cover claims up to state-set limits. Most states provide coverage of at least $250,000 per annuity contract. That said, insolvencies are rare, and the process of receiving a payout from a guaranty association can take weeks or months. Splitting a large annuity purchase between two highly rated insurers is one way to stay within guaranty limits and reduce concentration risk.
When Annuities Make the Most Sense
Annuities are most useful for people who have already maxed out other tax-advantaged retirement accounts (like 401(k)s and IRAs) and want additional tax-deferred growth, or for retirees who want a guaranteed income stream they can’t outlive. A straight life annuity essentially converts a pile of savings into a personal pension.
They’re less useful for younger investors who need liquidity, since surrender charges can lock your money up for years. The higher fee structures also mean that if you simply want market exposure during your working years, a low-cost index fund inside a retirement account will typically be cheaper. The value of an annuity comes from the insurance guarantees: a floor on losses, a lifetime income promise, or both. If those guarantees solve a specific problem in your retirement plan, the fees may be worth paying.