What Is an Annuity and How Does It Work?

An annuity is a contract between an investor and an insurance company that can provide a predictable stream of income, through a unique mix of insurance and investment features. Annuities offer tax-deferred growth and are often used to supplement other sources of retirement income, such as a pension plan, Social Security, a 401(k), or an IRA.

In exchange for a lump-sum payment or a series of premium payments, the insurance company promises to provide you with regular payouts, either starting immediately or at a future date. Your original investment is allowed to grow tax-deferred, until you take it out. Potential growth in your annuity may come from a guaranteed interest rate or exposure to market gains, depending on your contract.  

Every annuity involves two key components, making payments into the contract and receiving payouts from it. 

If you buy an annuity, you'll generally make a one-time payment or a series of regular payments to the insurer. Some contracts have flexible arrangements that allow you to pay as much as you want and choose your own payment schedule, within certain limits. Most annuities also include other fees or charges.

An annuity may pay out regular income for a set time period, the owner's lifetime, or the lifetime of the owner and spouse, depending on the specific terms of the annuity contract. Income payouts are generally paid monthly. The amount you receive depends on many factors, including the type of annuity, amount of your regular premium payment, your total account balance, and your age. Importantly, payouts are subject to the claims-paying ability of the insurance company.

There are two main types of annuities: immediate and deferred. While immediate annuities offer income in the short-term, deferred annuities offer payouts that start later. Immediate annuities are relatively straightforward, but deferred annuities are more complex and can be broken down into at least five common types, based on potential risk and returns.  

Here's a closer look.

Immediate annuities, also called single premium immediate annuities (SPIAs), are designed to provide income right now. You pay the insurance company with a lump sum and usually receive the first payout within 1 to 2 months. This is the simplest form of an annuity and is often used by people who have recently retired and want guaranteed cash flow for essential living expenses. Immediate annuities typically have no additional costs or fees and can work well as part of an investment portfolio.  

The premium you pay for an immediate annuity is typically irrevocable and cannot be refunded, once you turn it over. In exchange, the insurance company guarantees you a periodic payment, often for the rest of your life, or for the life of you and your spouse, regardless of future interest rates or market performance.

Deferred annuities generally make sense for retirement savings if your goal is future income. You invest money today, but payouts are scheduled for years in the future. Money you put in is allowed to grow tax-deferred, including any compounding interest or market gains, until it's withdrawn.  

Deferred annuity contracts generally include two phases: the accumulation period and the distribution phase.

• Accumulation period: This is when you pay money into the annuity and allow it to potentially grow. In addition to paying a single upfront premium, investors in deferred annuities may also pay annual or monthly premiums.  
• Distribution phase: Also called annuitization, this is when you start receiving steady payments from your annuity, based on your contract. At this time, the insurance company calculates your payout based on factors, such as total account value, life expectancy, age, current interest rates, and other options selected in your contract, such as lifetime payment or joint-and-survivor benefits.

• Deferred income annuities let you choose a point in the future when you want income payments to start, typically at least 13 months out from the initial purchase. Otherwise, they work like immediate annuities. Deferred income annuities can be a form of longevity insurance, or protection. But life expectancy is key, since payouts are affected by the length of time you allow your money to potentially grow.  
• Fixed deferred annuities generally pay a guaranteed minimum fixed interest rate over a set time period. While you may not benefit from positive market performance with this type of fixed annuity, your return rate generally won't fall below the minimum amount, even if the market falls lower. After the rate period expires, you can usually withdraw your money, exchange it into a new annuity, or renew it. If you renew, the insurance company will set another interest rate for the new time period, which may be higher or lower. 
• Fixed indexed annuities (also known as equity indexed annuities) typically pay a return based on performance of a market index, such as the S&P 500. But they may not credit any return to you when market growth is flat or negative. While these may pay more in positive market years (compared to fixed deferred annuities or other bond-like investments), they generally pay less in years with poor market growth. 
• Registered index-linked annuities are designed for investors who are more comfortable taking on additional market risk, compared to a fixed index annuity. These allow for greater potential growth tied to a market index, but also less protection in negative market years. In other words, if the market falls below the elected "buffer" protection level, your principal could also decline. 
• Variable annuities allow you to put money into investments (called subaccounts) that can go up or down in value. While the principal you invest may not be guaranteed, most variable annuities offer optional income protection riders, for an additional cost. Variable annuities generally give you greater market exposure (versus other deferred annuities), which may increase market risk and returns.

Most annuities offer a range of optional add-on features and benefits, called riders, for an additional fee. Like other annuity guarantees, riders are subject to the financial strength and claims-paying ability of the insurance company. Riders may also come with certain limitations or restrictions.  

Here are some of the most common annuity riders: 

• Guaranteed lifetime withdrawal benefit: Fixed index annuities, registered index-linked annuities, and variable annuities typically offer this optional rider (also called a living benefit), which guarantees minimum withdrawals for the owner's life, even if the annuity loses value due to market performance.  
• Guaranteed minimum income benefit: Often found in variable annuities, this rider guarantees your future income will be based on a minimum growth rate, regardless of how your subaccount investments perform.  
• Cost-of-living adjustments: These riders are designed to protect against inflation. They allow your monthly payout to be automatically increased by a set percentage every year (typically, 2% to 4%), to help keep your standard of living stable.  
• Long-term care conversion benefit: Some annuities allow you to withdraw funds penalty-free or increase your monthly income if you're diagnosed with a chronic illness or need home health care. This may be an alternative to regular long-term care insurance. 
• Death benefit: A death benefit rider guarantees any remaining value of your account will be passed to your designated beneficiaries, if you pass away before your contract ends or before receiving a certain amount of income. This may help support estate planning by allowing assets to pass directly to beneficiaries without probate. Beneficiaries who inherit an annuity will generally owe ordinary income tax on any earnings.  

Annuity payouts are generally taxed as ordinary income by the IRS. But there are differences in tax treatment, depending on the type of annuity, how you fund your annuity, and when you take your money out.

• Immediate vs. deferred annuity: Immediate and deferred annuities follow similar tax rules, but the timing is different. With immediate annuities, payouts start soon after you buy the contract and are taxable when you receive them. With deferred annuities, your principal and any earnings can grow tax-deferred, so you pay income tax later, when you receive payouts. For both types, the insurer will generally withhold taxes automatically, unless you opt out. 
• Qualified vs. nonqualified annuity: Annuities can be considered qualified or nonqualified, depending on how you fund them. A qualified annuity is funded with pre-tax dollars, often by rolling over a traditional IRA, 401(k), 403(b), or 457(b), and the entire payout is taxed as ordinary income when you receive it. A nonqualified annuity is funded with after-tax dollars, so only the earnings are taxed as ordinary income, while the principal is tax-free. Insurers use a formula called the exclusion ratio to determine how much of each nonqualified payout is taxable earnings versus tax-free principal.  
• Tax-deferred growth: Unlike a taxable brokerage account, where you pay tax on any capital gains you had during the year, earnings inside an annuity are not taxed annually. Instead, your money is allowed to potentially grow and compound (earn interest on interest) until you take it out of the account.  
• Early withdrawal rules: Annuity withdrawals taken before age 59½ may be subject to a 10% early withdrawal IRS tax penalty, on top of any surrender charges from the insurer. Other state or federal tax rules may also apply.  

Annuities can provide valuable benefits, but they aren't right for every investor. Before you buy an annuity, consider these potential drawbacks: 

• Surrender charges and liquidity constraints: A surrender charge is a fee you may pay for withdrawing money from an annuity before the surrender period ends. The surrender period is a specified number of years after you purchase the annuity, during which withdrawals above the contract's allowed amount may be subject to charges. Surrender charges are typically higher in the early years of the contract and often decline over time. Some contracts also limit penalty-free withdrawals, which can reduce access to your cash. 
• Fees and expenses: Some annuities, particularly variable annuities and annuities with optional riders, may include fees that can reduce overall returns. 
• Complexity: Annity contracts contain many details—including fees, riders, payout options, rates, and caps—that can be difficult to navigate without trusted guidance. 
• Limited upside in strong markets: Annuity returns in a high-performing market are generally lower, compared to investing directly in stocks or index funds. 
• Guarantees depend on the insurer: All guarantees of an annuity are subject to the financial strength and claims-paying ability of the insurance company that issues it. Strong insurers are more likely to meet their long-term commitments, including guaranteed income payments and optional rider benefits.  
• Inflation risk: Fixed annuity payments may lose purchasing power over time (unless you pay extra for an inflation-adjustment option).  
• Investment risk: Variable annuities can lose value due to market performance. Indexed annuities aren't invested directly in the market, but may include caps, participation rates, and other features that limit potential gains.  

Since contract terms vary and can be complex, ask questions about the risks and tradeoffs of your specific annuity offers before you buy. 

When considering annuities, do so within the context of your overall retirement income plan, including all your expected income sources and future expenses. While an annuity may not be a fit for every investor, it could make sense if you're concerned about outliving your savings or want a more structured, predictable way to pay yourself in retirement. When used thoughtfully, certain types of annuities may work well with other investments and strategies, to create a diversified retirement income portfolio.  

As always, understand the potential benefits and risks before you sign a contract or put money down. And consider talking with a trusted financial advisor or tax professional about strategies that align with your specific needs and goals.