An annuity is a contract between an investor, or annuitant, and an insurance company. The investor contributes money to the annuity in exchange for a guaranteed income stream later in life. The period when the investor is funding the annuity and before payouts begin is known as the accumulation phase. The period after payouts begin is the annuitization phase.

Annuities are typically sold as retirement-planning vehicles. In the U.S., annuity sales totaled $218 billion in 2018, a 9.7% increase over 2017, according to the Insured Retirement Institute (IRI), an industry group.

Two types of annuities are fixed and variable. Fixed annuities are not tied to specific investments or market indexes, so they provide a guaranteed rate of return regardless of market fluctuations. Variable annuities, on the other hand, are tied to mutual funds and other market-based securities. This is why many risk-averse investors choose fixed annuities: With a fixed annuity, slower growth is the price for the security of a set interest rate.

Key Takeaways

  • An investor contributes funds to an annuity in exchange for a guaranteed income stream later in life.
  • The type of fixed annuity—deferred or immediate—determines when payouts will start.
  • Investments in an annuity grow tax-free until they are withdrawn in retirement, at which point they are taxed at your then-current income tax rate.
  • Annuities have downsides: They are pricier than many other retirement investments, and withdrawals made during the first few years may be subject to surrender fees.

Immediate vs. Deferred Annuities

When the payouts from a fixed annuity will begin depends on whether it’s a deferred or an immediate annuity.

An immediate annuity must be purchased with a single, lump-sum payment. Payouts can begin immediately, and they usually continue for the rest of the annuitant's life. The amount of the monthly payout depends on the cost of the annuity, the payout option that the buyer chose, and personal factors such as their age. Immediate annuities are often attractive to retirees or soon-to-be retirees who are worried about potentially outliving their resources. An immediate annuity is also an option for someone who has received a large, one-time windfall, such as an inheritance or profits from selling a business, and wants to convert it into an income stream.

On the other hand, a deferred annuity will begin its payouts at some point in the future that's chosen by the buyer. With a deferred annuity, the annuitant either contributes a lump sum, makes a series of contributions over time, or does some combination of both. These kinds of annuities are aimed at investors who are still some years from retirement and don't need the income right away.

Retirement Payouts

A retiree who's ready to start receiving an income stream from their annuity notifies the insurance company. The insurer’s actuaries then calculate the amount of the periodic payment. This calculation includes such factors as the dollar value of the account, the annuitant's current age and life expectancy, the likely future returns on the account's assets, and whether or not the annuity is intended to provide income to a spouse after the annuitant dies.

Generally, the longer the annuitant waits before taking annuity payouts, the larger the payouts will be.

Most annuitants choose to receive monthly payments for the rest of their lives and their spouse's life, through a joint and survivor annuity. Once both are deceased, the insurer stops the payouts altogether.

Therefore, if an annuitant lives for a long time, the value they get from their annuity could be more than they paid for it. If they die too soon, however, they may collect less than they paid in. Nonetheless, both scenarios accomplish the main selling point of an annuity: income for the rest of life, however long or short it turns out to be. 

Annuities may also include additional provisions, such as a guaranteed number of payout years. With this option, if the annuitant and their spouse die before the guaranteed period is over, the insurer will pay the remaining funds to the couple's heirs. Generally speaking, the more provisions included in an annuity contract, the smaller the monthly payouts will be.

Risk-averse investors may prefer fixed annuities because they provide a guaranteed rate of return regardless of stock market fluctuations.

Factoring in Taxes

Most annuities offer tax advantages. Contributions are generally tax-deductible, and investment earnings grow tax-free until the annuitant begins to draw income from them. As with IRAs and other retirement accounts, those tax-deferred earnings can grow and compound more quickly over time than if the money was in a regular, taxable account.

Once the payouts start, the annuitant will have to pay taxes them at ordinary income tax rates, not capital gains rates, which are lower. That's also true of most kinds of retirement accounts. However, the annuitant may be in a lower tax bracket by then, as many people are in retirement.

Drawbacks to Consider

Annuities have their downsides. Their costs tend to be high compared with those of mutual funds and certificates of deposit, for instance. Annuities are often sold through agents, and the cost of their commission is passed on to the buyer. Annuities also come with sizable annual expenses, often in excess of 2%. Any special riders will usually increase the costs.

With many deferred annuities, the annuitant may have to pay a surrender fee if they withdraw funds during the early years of the contract (typically, six to eight years or even longer). Early distributions may also be subject to taxes before the annuitant reaches a certain minimum age. However, most annuities have provisions that allow penalty-free withdrawal of 10% to 15% of the account for emergency purposes.

Anyone who needs to take money from an annuity before regular payouts are supposed to begin should read their contract carefully and consider consulting a knowledgeable financial advisor.