Annuities: How They Work and When You Should Use Them

How annuities work

Where traditional life insurance protects against dying too soon, an annuity protects against the opposite problem: living longer than your savings can support. You pay an insurance company, which invests your money, and in exchange you receive a series of guaranteed periodic payments. If you take those payments over your lifetime, you're guaranteed income until you die, no matter how long that turns out to be. Die earlier than expected and the insurer keeps more than it paid out; live longer than expected and you can come out well ahead of what you put in. Compare that to a traditional investment account, which offers no such guarantee and can run dry before you do.

Earnings inside an annuity grow tax-deferred, meaning you owe no tax until the money is actually paid out, which gives your funds more room to compound than they would in a comparable taxable account.

Back to top

When annuities make sense

Before buying, weigh the cost of an annuity against simpler alternatives; buying life insurance and a tax-deferred investment separately is sometimes more cost effective than bundling both into an annuity. Annuities generally make sense for one of two goals: saving toward a long-range target, or locking in a guaranteed income stream for a set period. That makes them a natural fit for retirement funding, and in some cases education funding.

The tradeoff is liquidity. The tax code imposes a 10% penalty on money withdrawn from a tax-deferred annuity before age 59½, and insurers layer their own surrender charges on top for withdrawals made during the early years of the contract, typically the first seven. In practice, this means an annuity really only makes sense if you can leave the money in place for at least ten years and don't expect to need it before 59½, which is exactly why annuities tend to work best for retirement and, in narrower cases, for education funding timed to land after that age.

Annuities can be used to fund education costs by holding the account in a child's name under the Uniform Gifts to Minors Act, in which case the child pays tax and the 10% penalty on earnings at withdrawal. The major drawback is that the child is legally free to spend the money on anything once they gain control of it, not necessarily tuition.

Back to top

Types of annuities

Annuity products differ in how money goes in, how it comes out, and how it's invested along the way.

• Single-premium annuities are funded with one lump-sum payment, often a distribution from a retirement plan, typically with a minimum investment of $5,000 to $10,000.
• Flexible-premium annuities are funded through a series of payments over time, starting with a relatively small initial contribution.
• Immediate annuities begin paying out right after they're funded, usually with a single premium, and are most often purchased by retirees using accumulated retirement savings.
• Deferred annuities delay payouts for years after the contract is issued, and can be taken as a lump sum or as regular payments once the payout period begins. They're used by both retirees and pre-retirees as long-term, tax-deferred savings vehicles.

Annuities are also categorized by how the underlying funds are invested. A fixed annuity puts your money into conservative, fixed-income investments, guarantees your principal, and locks in an interest rate for a set period, similar in structure to a CD, with a guaranteed minimum rate typically between 3% and 5% for the life of the contract. It's a good fit for a low-risk tolerance and a shorter time horizon, though the tradeoff is modest growth, and fixed annuity holders benefit when rates fall but not when they rise.

A variable annuity carries more risk, roughly comparable to a mutual fund, and lets you allocate your money across several managed sub-funds, typically stocks, bonds, and cash equivalents, with no guarantee of principal or a set return, though earnings still grow tax-deferred. You can generally reallocate between the sub-funds for a small fee or sometimes free. Variable annuities suit a higher risk tolerance and a longer time horizon, but tend to carry higher costs than a comparable non-insurance investment, and the taxable portion of a distribution is taxed at full ordinary income rates, with none of the capital gains relief available on comparable stock or mutual fund investments held outside an annuity.

Some products blend fixed and variable features. Before buying any annuity, it's generally worth maxing out other tax-deferred options first, IRAs and 401(k)s in particular, since their fees tend to run lower and annuity early-withdrawal penalties can be steep. IRA funds are sometimes invested in flexible-premium annuities, but since assets inside an IRA already grow tax-deferred, wrapping an annuity around them adds a layer of annuity-specific cost without adding any tax benefit you didn't already have.

Back to top

Choosing a payout option

When it's time to start taking money out of a deferred annuity, you'll typically choose between a monthly payment stream or a lump sum, and once you choose, you generally can't change your mind. The size of your payout depends on the amount in the contract, any minimum required payments, your life expectancy or chosen payout period, and whether payments continue after your death.

• Fixed amount: pays a set monthly amount you choose until the annuity is exhausted. The risk is outliving the payments; if you die first, your beneficiary receives what's left.
• Fixed period: pays a set amount over a period you choose, useful for bridging income before another benefit starts. Your beneficiary receives the remainder if you die before the period ends.
• Lifetime or straight life: pays until you die, with nothing to survivors, offering the highest monthly benefit of any option but the risk of leaving money on the table if you die early.
• Life with period certain: pays for life, but guarantees a minimum payment period to you or a beneficiary even if you die early. The longer the guarantee period, the lower the monthly benefit.
• Installment-refund: pays for life and guarantees that any unused original investment goes to a beneficiary if you die early, at a lower monthly payment than straight life.
• Joint and survivor: continues payments to a surviving spouse or co-annuitant after the first annuitant's death, at the same or a reduced amount, with the exact terms depending on the ages involved and the percentage elected for the survivor.

Back to top

How payouts are taxed

Taxation depends on whether the annuity is qualified or non-qualified.

Qualified annuities fund a qualified retirement plan, such as an IRA, Keogh, 401(k), or SEP, and inherit the full tax treatment of that plan. Any after-tax amount you contributed isn't taxed again on withdrawal, and earnings aren't taxed until withdrawn. Withdraw before age 59½ and you'll generally owe a 10% penalty on top of ordinary income tax, though exceptions exist, including taking withdrawals as a series of substantially equal periodic payments over your remaining life. Required minimum distributions currently begin at age 73 for individuals who reached age 72 after 2022 and turn 73 before 2033, and at age 75 for those who turn 74 after 2032, under the SECURE Act 2.0 changes. Roth IRAs and employees still working past the applicable age are exempt.

Non-qualified annuities are purchased with after-tax dollars, so only the earnings portion of a withdrawal is taxable, and the 10% early-withdrawal penalty, if it applies, is calculated only on that earnings portion, not the full withdrawal.

If your annuity continues after your death, income tax rules apply to your beneficiary the same way they'd have applied to you, though the 10% early-withdrawal penalty doesn't apply to a beneficiary regardless of either party's age. The present value of remaining annuity payments is also included in your estate for estate tax purposes, unless the annuity passes to a surviving spouse or to charity, in which case it's excluded.

Back to top

How to shop for an annuity

Annuities are typically issued by insurance companies but can be purchased through banks, insurance agents, or brokers, and both fees and product quality vary widely, which makes comparison shopping worthwhile.

Start by checking the insurer's financial strength, since annuities aren't federally guaranteed the way bank deposits are; rating services like A.M. Best, Moody's, or S&P Global's Ratings can tell you how a given insurer is rated. From there, how you compare specific contracts depends on the type: for immediate annuities, compare the monthly payout per $1,000 invested along with any penalties; for deferred annuities, compare the guaranteed rate, the length of the guarantee period, and the insurer's five-year history of rates actually paid, not just the headline rate; for variable annuities, look at the historical performance of the underlying sub-funds and whether the management team behind a strong track record is still in place.

Back to top

Costs, penalties, and extras

Before signing an annuity contract, compare the surrender charges for early withdrawal, typically starting around 7% in year one and stepping down a point or two each year until they disappear, usually by year seven or eight; be cautious of any contract with a longer schedule or steeper charges than that. Confirm that the surrender charge clock starts on your original contract date, not with each new deposit you make.

Ask about every fee that applies. With variable annuities, fees must be disclosed in the prospectus and typically include a mortality and expense fee of 1% to 1.35% of your account value, an annual maintenance fee of $20 to $30, and investment advisory fees of 0.3% to 1% on the underlying sub-fund assets. Also ask about optional features that aren't costs but are worth understanding upfront, such as bail-out provisions letting you exit without surrender charges if rates fall below a stated level, or persistency bonuses rewarding you for holding the annuity a minimum number of years. Given the complexity of these tradeoffs, it's worth getting professional guidance before committing to a specific annuity.

Back to top

The risk of an immediate annuity for retirees

An immediate annuity can look appealing to retirees with a lump-sum distribution from a retirement plan: convert the lump sum into guaranteed periodic payments for life, with the portion representing return of principal excluded from taxable income. But the strategy carries real risks. Locking into level payments leaves you unprotected against inflation over a potentially long retirement. You're also betting on longevity: put in $150,000 and die after collecting $60,000, and the insurer typically keeps the difference rather than passing it to your heirs, unlike most other investments. And because the rate is fixed at purchase, you could be locking in a low rate for the rest of your life.

Some of these risks can be hedged. A "period certain" or "term certain" provision guarantees payments to your beneficiaries for a set number of years even if you die early. Joint-and-survivor options extend payments to a spouse after your death. Refund features return some or all of the unused principal to your beneficiaries. Some contracts even build in modest cost-of-living adjustments, though accepting any of these features generally means a lower monthly payment than the plain version of the annuity.

A newer variation, the variable immediate annuity, ties monthly payments to the performance of a basket of underlying mutual funds in exchange for potentially higher returns and some market risk. For most retirees, a balanced portfolio of mutual funds paired with a deliberate, longer-horizon withdrawal plan achieves a similar goal, guarding against outliving your money, without permanently locking up the funds the way an immediate annuity does.

Back to top