An annuity is a contract between an investor, or annuitant, and an insurance company. The investor contributes funds 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 the accumulation phase. The time after payments from the annuity begin is called the annuitization phase.

Annuities remain popular retirement-planning vehicles. In the U.S., annuity sales totaled $218 billion in 2018 and notched a 9.7% increase over 2017, according to the Insured Retirement Institute (IRI). For the first quarter of 2019, sales dipped slightly, to $57.8 billion, from the previous quarter but were still solidly above sales from the same period a year ago, when they hit $49.2 billion.

Two types of annuities are fixed and variable. Fixed annuities are not tied to economic indicators or market indexes, so they provide a guaranteed rate of return regardless of stock 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.

The type of annuity and its contractual details are key in planning for retirement income.

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  • Investments in an annuity grow tax free until they are withdrawn in retirement, at which point they are taxed at your then-current income tax rate.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 can payouts from a fixed annuity begin? That 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 usually last the rest of the annuitant's life. The size of the monthly payout depends on the amount used to buy the annuity, the payout option chosen, and such personal factors as the annuitant's age. Immediate annuities are popular with retirees or soon-to-be retirees who are worried about potentially outliving their resources. An immediate annuity is also a great option for anyone who just received a large, one-time windfall, such as an inheritance, profits from selling a business, or lottery winnings.

On the other hand, a deferred annuity allows one to build account value over time and convert it to income in the future. 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 annuities are popular with younger investors who are looking to build retirement savings while still working.

Retirement Payouts

A retiree who's ready to start receiving an income stream from an annuity notifies the insurance company. The insurer’s actuaries use a special calculation to determine the amount of the periodic payment. This calculation includes such factors as the dollar value of the account, the annuitant's current age, expected future returns from the account's assets, spousal provisions, and the annuitant's life expectancy based on standard life-expectancy tables.

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. Under this provision of a joint and survivor annuity, the annuitant and their spouse will continue to receive payouts for the remainder of their lifetimes. Once both are deceased, the insurer stops the payouts.

Therefore, if an annuitant lives a long time during retirement, the total value from the annuity contract could be significantly more than what they paid into it. If the annuitant dies relatively early, however, they may actually receive less than what they paid in. Nonetheless, both scenarios accomplish the main point of an annuity: peace of mind that the annuitant will receive income for the rest of their life. 

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 pays the remaining funds to the couple's estate. For the most part, the more provisions included in an annuity contract, the smaller the monthly payouts.

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 sheltering, which means contributions to an annuity reduce the annuitant's taxable earnings for the current year, and investment earnings grow tax-free until the annuitant begins to draw an income from them. Over a long period, tax savings can compound and result in substantially boosted returns.

Once payouts start, the annuitant must pay taxes on that income. However, because a taxpayer typically falls into a lower tax bracket after retirement, the average annuitant will likely pay significantly lower taxes on the payouts than if they had claimed the income when they earned it. In the end, this provides an even higher after-tax return on the investment.

The income portion is also taxed at ordinary income tax rates, not capital gains rates, which are lower.

Drawbacks to Consider

Annuities have their down side. Their costs are 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%. Special riders usually increase costs.

With many deferred annuities, the annuitant may have to pay a surrender fee if they withdraw funds within the first few 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 10-15% of the account for emergency purposes.

It’s important to carefully read an annuity contract and consult a tax professional before withdrawing from an annuity.

The Bottom Line

How an annuity works after one's retirement will vary depending on a number of factors, including whether the annuity is immediate or deferred, provisions in the contract, the annuitant's age, and how much money is in the account. One thing is certain: Annuities can offer post-retirement peace of mind because they provide a guaranteed stream of income throughout what remains of one's life.