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 Funds accrue on a tax-deferred basis, and like 401(k) contributions, can only be withdrawn without penalty after age 59.5.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.