Key takeaways
- An annuity is an insurance contract that provides guaranteed income payments in exchange for a lump sum or series of payments.
- There are five main types of annuities: immediate, fixed deferred, fixed indexed deferred, variable deferred, and registered index-linked (RILAs).
- Earnings grow tax-deferred, meaning taxes aren't owed until money is withdrawn.
- Annuities can provide income you can't outlive, making them valuable for retirement planning.
- Consider surrender charges, liquidity restrictions, and fees before purchasing.
But not everyone understands how they can fit into a secure retirement, so let's find out what annuities do and how they work.
What is an annuity?
An annuity is an insurance contract that provides guaranteed income payments in exchange for a lump sum or series of payments. Annuities can only be issued by insurance companies. Whereas life insurance protects against the risk of dying too soon, annuities protect against the risk of living too long. Annuities are one of the few financial products that can guarantee an income you can't outlive.
There are often two phases of an annuity – the accumulation phase and the income distribution phase, otherwise known as "annuitization." You can use a lump sum to purchase an annuity or send payments on a regular basis and your contribution earns interest or investment returns. Earnings accumulate tax-deferred, which means taxes aren't owed until money is withdrawn, which typically occurs at retirement.
At some point in the future, you may elect to turn your accumulated value into an income stream. When you annuitize your contract, you receive a guarantee on the schedule and duration of your income payments. You will likely have options to choose income for life or a set period of time as well as basing it on a single life or two lives (joint).
Types of annuities
There are five main types of annuities:
- Immediate annuity – Generates guaranteed income starting within a year after purchase ("income now").
- Fixed deferred annuity – Offers guaranteed growth at a specific interest rate with lower risk and predictability.
- Fixed indexed deferred annuity – Earns interest linked to index performance with protection from market downturns.
- Variable deferred annuity – Allows investment in variable options with market participation and associated risks.
- Registered index-linked annuity (RILA) – Reduces downside risk against market losses while providing growth potential.
An immediate annuity offers the opportunity to generate a guaranteed stream of income, starting within a year after purchase. Think of immediate annuities as "income now."
Think of a deferred annuity as "income later" where you defer income to sometime in the future. There are four types of deferred annuities.
Fixed deferred annuities offer guaranteed growth at a specific interest rate, making them lower-risk and predictable.
Fixed indexed deferred annuities offer the opportunity to earn interest linked to the changes in performance of an index. Fixed indexed annuities offer protection from market downturns but still allow you to earn higher interest than you would with many fixed interest products.
Variable deferred annuities offer the ability to invest your contributions in variable investment options, making them a good fit for those who want market participation and are prepared to face market risk (and the ups and downs that go along with it).
Registered index-linked annuities (RILAs) are retirement products designed to reduce downside risks against market losses, while still providing the potential for growth - a direct trade-off between protection and maximum returns.
Pros and cons of annuities
Advantages:
- Guaranteed income, with options that allow income for life or certain periods
- Tax-deferred growth on earnings
- No contribution limits on nonqualified annuities (unlike 401(k) plans)
- Protection from market downturns (with certain annuity types)
- Optional benefits for accumulation, income, or legacy needs
Disadvantages:
- Surrender charges for early withdrawals (surrender periods vary by product)
- 10% federal tax penalty for withdrawals before age 59½
- Liquidity restrictions during the surrender period
- Fees vary and some annuities are more expensive than others
- Not suitable for everyone's financial situation
Considerations when thinking about an annuity
When evaluating an annuity, keep these key factors in mind:
- Surrender charges: Penalties apply for withdrawing money during the surrender period, which varies by product.
- Tax penalties: Withdrawals made before age 59½ may be subject to a 10% federal tax penalty.
- Liquidity restrictions: Access to your money is limited during the surrender period; liquidity options increase once it ends.
- Fees: Understand all fees associated with your annuity, as costs vary significantly between products.
- Long-term commitment: Make sure you're ready for a long-term decision before purchasing.
Why buy an annuity?
There are several good reasons to purchase an annuity.
Perhaps you've maxed out your other tax-advantaged retirement plans, such as your 401(k) and IRA. With a nonqualified deferred annuity you can deposit as much money as you want — there is no legal limit (there may be specific product limits).
If you're close to retirement age, buying an annuity can help you feel a sense of security by providing a guaranteed income during your retirement years.
Annuities aren't what they used to be. Many of them now offer more liquidity and lower costs. In addition, you can usually purchase optional benefits (for an additional cost) to accommodate specific accumulation, income or legacy needs.
An annuity won't take care of every financial retirement issue you'll face, and they're not a perfect fit for everyone. But they can go a long way toward making the financial side of retirement less challenging.
Frequently asked questions
How are annuities taxed?
Earnings in an annuity grow tax-deferred, meaning you don't pay taxes until you withdraw money. When distributed, earnings are taxed as ordinary income. Withdrawals before age 59½ may also be subject to a 10% federal tax penalty.
What happens to an annuity when you die?
Annuities typically offer options for beneficiaries, and you can often choose income based on a single life or two lives (joint). Specific death benefit options vary by contract, so review your annuity's terms or consult a financial professional.
Are annuities a good investment?
Annuities can be valuable for those seeking guaranteed retirement income and tax-deferred growth, especially if you've maxed out other retirement accounts. However, they're not ideal for everyone due to surrender charges, fees, and liquidity restrictions. Consider your financial goals and timeline before purchasing.
Key terms
- Accumulation phase: The period when you make contributions to your annuity and your money grows through interest or investment returns.
- Annuitization: The process of converting your accumulated annuity value into a stream of income payments.
- Surrender period: A set timeframe during which withdrawing money from your annuity results in penalty charges.
- Nonqualified annuity: An annuity purchased with after-tax dollars that has no contribution limits, unlike qualified retirement accounts.
