An annuity is a contract between you and an insurance company in which you make a lump sum payment or series of payments and in return obtain regular disbursements beginning either immediately or at some point in the future.

The goal of annuities is to provide a steady stream of income during retirement. Funds accrue on a tax-deferred basis, and like 401(k) contributions, can only be withdrawn without penalty after age 59.5.

Many aspects of an annuity can be tailored to the specific needs of the recipient. In addition to choosing between a lump sum payment or a series of payments to the insurer, you can choose when you want to annuitize your contributions - that is, start receiving payments. An annuity that begins paying out immediately is referred to as an immediate annuity, while those that start at a preset date in the future are called deferred annuities.

The duration of the disbursements can also vary. You can choose to receive payments for a specific period of time - for example, 25 years - or obtain them until your death. Of course, securing a lifetime of payments lowers the amount of each check, but it helps ensure that you don't outlive your assets.

Annuities come in three main varieties - fixed, variable and indexed - that each have their own level of risk and payout potential. Fixed annuities pay out a guaranteed amount based on the balance of your account. The downside of this predictability is a modest annual return, generally slightly higher than a CD.

You have the opportunity for a higher return, accompanied by greater risk, with a variable annuity. In this case, you pick from a menu of mutual funds that comprise your personal "subaccount." Here, your payments in retirement are based on the performance of investments in your subaccount.

Indexed annuities are somewhere in between when it comes to risk and potential reward. You receive a guaranteed minimum payout, although a portion of your disbursements is tied to the performance of a market index, such as the S&P 500.

Despite their potential for greater earnings, variable and indexed annuities are sometimes criticized for their fees and their relative complexity. For example, many annuitants find that they have to pay steep surrender charges if they try to get their money out within the first few years of the contract.

An important feature to consider with any annuity is its tax treatment. While your balance grows tax-free, disbursements are subject to income tax. Conversely, mutual funds that you hold for over a year are taxed at the long-term capital gains rate. And unlike 401(k) accounts, contributions to annuities don't reduce your taxable income. For this reason, some finance experts recommend annuities only after maximizing your contributions to pretax retirement accounts.

  1. For what types of financial instruments would I want to calculate the present value ...

    Learn about the types of financial instruments the present value of an annuity calculation is most useful for, including ... Read Answer >>
  2. What type of investor should consider annuities?

    Learn about the features and benefits of annuities and when to consider one. Investors seeking to secure income for retirement ... Read Answer >>
  3. How liquid are variable annuities?

    Understand whether variable annuities are liquid. Learn more about the two types of variable annuities and which is more ... Read Answer >>
  4. What are the best ways to sell an annuity?

    Learn about the best ways to sell annuities. Annuities are financial products that provide income on a regular basis to their ... Read Answer >>
Related Articles
  1. Retirement

    How a Fixed Annuity Works After Retirement

    These popular investments can provide a steady stream of income during your retirement years. Here are the details.
  2. Financial Advisor

    An Overview Of Annuities

    These contracts provide a guaranteed income stream. Learn how they work and their benefits.
  3. Retirement

    What Role Should Annuities Play in Retirement?

    Fixed annuities can provide income protection for those worried about outliving their assets. But don't buy a bigger policy than you really need.
  4. Financial Advisor

    Annuities: The Good, Bad and the Ugly

    Annuities suffer from a few perception problems. This primer that covers the good, the bad and the ugly of annuities.
  5. Retirement

    Retirement Tips: Choose the Best Annuity Provider

    It pays to get the best advice if you are thinking of putting your money into one of these complicated investments.
  6. Retirement

    Getting the Whole Story on Variable Annuities

    Variable annuities are another way to save money tax-deferred - but don't jump in blindly!
  7. Financial Advisor

    Advising FAs: Explaining Annuities to a Client

    Conceptually speaking, annuities can be thought of as a reverse form of life insurance.
  8. Retirement

    Guaranteed Retirement Income In Any Market

    By laddering annuities, you can be sure you'll have income no matter what the market does.
  1. Annuity

    A financial product that pays out a fixed stream of payments ...
  2. Valuation Period

    The time between the end of the business day of the first business ...
  3. Annuity Consideration

    The money that an individual pays to an insurance company in ...
  4. Delayed Annuity

    An annuity in which the first payment is paid at a later date ...
  5. Cash Refund Annuity

    An annuity contract that returns funds back to a beneficiary ...
  6. Whole Life Annuity Due

    A financial product sold by insurance companies that requires ...
Hot Definitions
  1. Perkins Loan

    A loan program that provides low-interest student loans to undergraduate and graduate students who demonstrate exceptional ...
  2. Wealth Management

    A high-level professional service that combines financial/investment advice, accounting/tax services, retirement planning ...
  3. Assets Under Management - AUM

    The market value of assets that an investment company manages on behalf of investors. Assets under management (AUM) is looked ...
  4. Subprime Auto Loan

    A type of auto loan approved for people with substandard credit scores or limited credit histories. There is no official ...
  5. Racketeering

    A fraudulent service built to serve a problem that wouldn't otherwise exist without the influence of the enterprise offering ...
  6. Federal Debt

    The total amount of money that the United States federal government owes to creditors. The government's creditors include ...
Trading Center