If you are considering buying an annuity to provide steady income during retirement, it's important to understand the different types and how they work. Here's a look at the fundamentals of annuities and what to consider before making a decision.

Key Takeaways

  • Investors typically buy annuities to provide a steady income stream during retirement.
  • Immediate annuities pay income right away, while deferred annuities pay it at some future date.
  • Annuities provide tax-deferred investment growth, but you have to pay income taxes on the money when you withdraw it. 
  • Most annuities penalize investors for early withdrawals, and many have high fees.

Annuities: The Big Picture

An annuity is a contract between you—the annuitant—and an insurance company. In return for your contributions, the insurer promises to pay you a certain amount of money, on a periodic basis, for a specified period. Many people buy annuities as a kind of retirement-income insurance, guaranteeing them a regular income stream after they've left the workforce, often for the rest of their life.

Most annuities also offer tax advantages. The investment earnings grow tax-free until you begin to withdraw income. This feature can be attractive to young investors, who can contribute to a deferred annuity for many years and take advantage of tax-free compounding in their investments.

Annuities typically have provisions that penalize investors if they withdraw funds early. Also, tax rules generally encourage investors to postpone withdrawals until they reach a minimum age. However, most annuities allow investors to withdraw 10% to 15% of the account for emergency purposes without penalty.

Compared with other types of investments, annuities can also have relatively high fees.

How Annuities Work

There are two main categories of annuities, based on when they begin to pay out: immediate and deferred.

With an immediate annuity, you give the insurance company a lump sum of money and start receiving payments right away. Those payments can either be a fixed amount or a variable one, depending on the contract.

Annuities often have high fees, so shop around and make sure you understand all of the expenses before purchasing one.

Typically, you might choose this type of annuity if you have a one-time windfall, such as an inheritance. People who are close to retirement may also take a portion of their retirement savings and buy an immediate annuity as a way to supplement their income from Social Security and other sources.

Deferred annuities are structured to meet a different investor need—to accumulate capital over your working life, which can then be converted into an income stream for your later years.

The contributions you make to the annuity grow tax-deferred until you take income from the account. This period of regular contributions and tax-deferred growth is called the accumulation phase.

You can purchase a deferred annuity with a lump sum, a series of periodic contributions, or a combination of the two.

Types of Annuities

Within the broad categories of immediate and deferred annuities, there are also several different types from which to choose. Those include fixed, indexed, and variable annuities.

Fixed Annuities

A fixed annuity provides a predictable source of retirement income, with relatively low risk. You receive a specific amount of money every month for the rest of your life or another period you've chosen, such as 5, 10, or 20 years.

Fixed annuities offer the security of a guaranteed rate of return. This will be true regardless of whether the insurance company earns a sufficient return on its own investments to support that rate. In other words, the risk is on the insurance company, not you. That's one reason to make sure you're dealing with a solid insurer that gets high grades from the major insurance company credit rating agencies.

The downside of a fixed annuity is that if the investment markets do unusually well, the insurance company, not you, will reap the benefits. What's more, in a period of serious inflation, a low-paying fixed annuity can lose spending power year after year.

Your state's department of insurance has jurisdiction over fixed annuities because they are insurance products. Also, your state insurance commissioner requires that advisors have a license to sell fixed annuities. You can find contact information for your state's insurance department on the National Association of Insurance Commissioners website.

Indexed Annuities

Indexed annuities, also called equity-indexed or fixed-indexed annuities, combine the features of a fixed annuity with the possibility of some additional investment growth, depending on how the financial markets perform. You're guaranteed a certain minimum return, plus a return pegged to any rise in the relevant market index, such as the S&P 500.

Indexed annuities are regulated by state insurance commissioners as insurance products, and agents must have a fixed annuity license to sell them. The Financial Industry Regulatory Authority (FINRA), a self-regulatory organization for the securities industry, also requires that its member firms monitor all products their advisors sell, so if you deal with a FINRA member firm, you might have another set of eyes unofficially watching the transaction. This FINRA investor alert has more details.

Variable Annuities

Rather than being tied to a market index, as indexed annuities are, variable annuities provide a return that's based on the performance of a portfolio of mutual funds you've selected. The insurance company may also guarantee a certain minimum income stream if the contract includes a guaranteed minimum income benefit option.

Unlike fixed and indexed annuities, a variable annuity is considered a security under federal law and is subject to regulation by the Securities and Exchange Commission (SEC) and FINRA. Potential investors must also receive a prospectus.

When you buy an annuity, you're gambling that you'll live long enough to get your money's worth—or, ideally, more than that.

Tax Benefits of Annuities

Annuities offer several tax benefits. In general, during the accumulation phase of an annuity contract, your earnings grow tax-deferred. You pay taxes only when you start taking withdrawals from the annuity. Withdrawals are taxed at the same tax rate as your ordinary income.

If you fund an annuity through an individual retirement account (IRA) or another tax-advantaged retirement plan, you may also be entitled to a tax deduction for your contribution. This is known as a qualified annuity.

Taking Distributions From Annuities

Once you decide to start the distribution phase of your annuity, you inform your insurance company. The insurer's actuaries then determine your periodic payment amount by means of a mathematical model.

The primary factors that go into the calculation are the current dollar value of the account, your current age (the longer you wait before taking an income, the greater your monthly payments will be), the expected future inflation-adjusted returns from the account's assets, and your life expectancy based on industry-standard life-expectancy tables. Finally, the spousal provisions included in the contract are factored into the equation. Most annuitants choose to receive monthly payments for the rest of their lives and their spouse's lives, in case their spouses outlive them.

If you live for a long time after you start taking distributions, the total value you receive from your annuity contract could be significantly higher than what you paid into it. However, should you die relatively soon, you may not get your money's worth.

Annuities can have many other provisions, such as a guaranteed number of payment years. Under that provision, if you (and your spouse, if applicable) die before the guaranteed payment period is over, the insurer pays the remaining funds to your heirs.

Generally, the more guarantees in an annuity contract, the smaller your monthly payments will be.

What to Consider

Annuities may make sense as part of an overall retirement plan, especially if you are uncomfortable with investing or concerned about outliving your assets. But before you buy one, be sure to consider the following questions:

  • Will you use the annuity primarily to save for retirement or a similar long-term goal? If not, another investment may be preferable.
  • In the case of a variable annuity, how would you feel if the account's value fell below the amount you had invested because the underlying portfolio performed poorly? That can happen.
  • Do you understand all of the annuity's fees and expenses?
  • Are you reasonably certain you'll be able to hold the annuity long enough to avoid paying surrender charges? Do you have other assets you could draw on if you faced an unexpected financial emergency?