If you are considering 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 adding one to a retirement portfolio.

Annuities: The Big Picture

Most investors share the same goal of long-term wealth accumulation. But some have no problem watching their investments bounce up and down from day to day, while risk-averse investors or those nearing retirement generally can't tolerate much short-term volatility within their portfolios. If you are this type of investor—or one who has a low to moderate risk toleranceannuities can be a valuable investment tool.

Key Takeaways

  • Investors typically purchase annuities to provide a steady income stream during retirement.
  • Immediate annuities and deferred annuities are the two major types of annuity contracts.
  • Tax benefits include tax-deferred growth, but you pay income taxes on the money withdrawn. 
  • Most annuities penalize investors for early withdrawals. 

An annuity is a contract between you—the annuitant—and an insurance company, who promises to pay you a certain amount of money, on a periodic basis, for a specified period. The annuity provides a kind of retirement-income insurance: You contribute funds to the annuity in exchange for a guaranteed income stream later in life. Typically, annuities are purchased by investors who wish to guarantee themselves a minimum income stream during their retirement years.

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

Because they are a long-term retirement planning instrument, annuities typically have provisions that penalize investors if they withdraw funds before accumulating for a minimum number of years. Also, tax rules generally encourage investors to prolong withdrawing annuity funds until a minimum age. However, most annuities have provisions that allow about 10% to 15% of the account to be withdrawn for emergency purposes without penalty.

How Annuities Work

Generally speaking, there are two primary ways annuities are constructed and used by investors: immediate annuities and deferred annuities.

With an immediate annuity, you contribute a lump sum to the annuity account and immediately begin receiving regular payments, which can be a specified, fixed amount, or variable depending upon your choice of annuity package. The payout will not change for the rest of your life.

Annuities are often associated with high fees, so make sure you understand all of the expenses before purchasing one.

Typically, you would choose this type of annuity if you have experienced a one-time payment of a large lump sum, such as lottery winnings or an inheritance. Immediate annuities convert a cash pool into a lifelong income stream, providing you with a guaranteed monthly allowance for your old age. Sometimes people close to retirement purchase these with some portion of their retirement savings to add to their guaranteed income in retirement.

Deferred annuities are structured to meet a different type of investor need—to accumulate capital over your working life to build a sizable income stream for your retirement. The regular contributions you make to the annuity account grow tax-sheltered until you choose to draw an income from the account. This period of regular contributions and tax-sheltered growth is called the accumulation phase.

Sometimes, when establishing a deferred annuity, an investor may transfer a large sum of assets from another investment account, such as a pension plan. In this way, the investor begins the accumulation phase with a large lump-sum contribution, followed by smaller periodic contributions.

Types of Annuities

Different investors place different values on a guaranteed retirement income. Some believe it is critical to secure risk-free income for their retirement. Other investors are less concerned about receiving a fixed income from their annuity investment than they are about continuing to enjoy capital gains on their funds. Which needs and priorities you have will determine whether you choose a fixed or variable annuity.

Fixed Annuities

A fixed annuity provides a low-risk retirement income source—you receive a fixed amount of money every month for the rest of your life. A fixed annuity offers the security of a guaranteed rate of return. This will be true regardless of whether the insurance company that manages your annuity earns a sufficient rate of return on its own investments to support that rate.

However, the price for removing risk is missing out on growth opportunity. Should the financial markets enjoy bull market conditions during your retirement, you forgo additional gains on your annuity funds.

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 yours on the National Association of Insurance Commissioners website.

Indexed Annuities

Indexed annuities, also called equity-indexed or fixed-indexed annuities, are fixed deferred annuities that credit earnings based on the movement of an index, such as the S&P 500. This type of annuity also guarantees a certain minimum return and allows you to participate in stock market gains without assuming the full risk of losing money when the market declines.

Indexed annuity sales are a jurisdictional jump ball. It isn't clear to anyone whether they're insurance products or securities, even though they may look likeannuities to investors. As you can imagine, this has created much controversy among regulators and the insurance industry.

At the moment, because insurers bear the financial risk, indexed annuities are regulated by state insurance commissioners as insurance products, and agents must have a fixed annuity license to sell them. However, the Financial Industry Regulatory Authority (FINRA) requires that its member firms monitor all products their advisors sell. What's more, FINRA issued an investor alert on indexed annuities. Therefore, if you deal with an FINRA member firm, you might have another set of eyes unofficially watching the transaction.

Variable Annuities

Variable annuities allow you to participate in the potential appreciation of your assets while still drawing an income from your annuity. With this type of annuity, you receive varying rates of return depending on your portfolio's performance. The insurance company typically guarantees a minimum income stream, through what is called a guaranteed income benefit option, and offers an excess payment amount that fluctuates with the performance of the annuity's investments.

You enjoy larger payments when your managed portfolio renders high returns and smaller payments when it does not. Variable annuities may offer a comfortable balance between guaranteed retirement income and continued growth exposure.

Anyone selling a variable annuity must have a Series 6 or Series 7 license, and your state may require one as well.

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 receive a prospectus.

Tax Benefits of Annuities

Annuities offer several tax benefits. In general, during the accumulation phase of an annuity contract, earnings grow tax deferred. You pay income taxes when you start taking withdrawals from the annuity.

If you contribute funds to the annuity through an IRA or another tax-advantaged retirement account, you are also usually able to annually defer taxable income equal to the amount of your contributions, giving you tax savings for the year of your contributions. Over a long period of time, your tax savings can compound and result in substantially boosted returns.

It's also worth noting that since you're likely to earn less in retirement than in your working years, you will probably fit into a lower tax bracket once you retire. This means you will pay less in taxes on the assets than you would have had you claimed the income when you earned it. In the end, this provides you with even higher after-tax return on your investment.

Taking Distributions from Annuities

The goal of an annuity is to provide a stable, long-term income supplement for the annuitant. Once you decide to start the distribution phase of your annuity, you inform your insurance company of your desire to do so. The insurer employs actuaries who then determine your periodic payment amount by means of a mathematical model.

The primary factors taken into account in the calculation are the current dollar value of the account, your current age (the longer you wait before taking an income, the greater your 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 annuity contract are also factored into the equation.

Most annuitants choose to receive monthly payments for the rest of their lives and their spouse's lives (meaning the insurer stops issuing payments only after both parties are deceased). If you chose this distribution arrangement and you live for a long time after you retire, the total value you receive from your annuity contract may be significantly more than what you paid into it. However, should you pass away relatively early, you may receive less than what you paid the insurance company. Regardless of how long you live, the primary benefit you receive from your contract is peace of mind: guaranteed income for the rest of your life.

Furthermore, while it is impossible for you to predict your lifespan, your insurance company need only be concerned with the average retirement lifespan of all their clients, which is relatively easy to predict. Thus, the insurer operates on certainty, pricing annuities so that it will marginally retain more funds than its aggregate payout to clients. At the same time, each client receives the certainty of a guaranteed retirement income.

Annuities can have other provisions, such as a guaranteed number of payment years. If you (and your spouse, if applicable) die before the guaranteed payment period is over, the insurer pays the remaining funds to the your estate. Generally, the more guarantees inserted into an annuity contract, the smaller the monthly payments will be.

What to Consider

Annuities may make sense as part of an overall retirement plan. But before you buy one, consider the following questions:

  • Will you use the annuity primarily to save for retirement or a similar long-term goal?
  • Are you investing in the annuity through a tax-advantaged retirement plan? If yes, do you realize that you will not receive any additional tax-deferral benefit?
  • 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?
  • Do you understand all of the annuity's fees and expenses?
  • Do you intend to hold the annuity long enough to avoid paying surrender charges when you withdraw money?
  • Have you thought about how your tax liability might be affected when you begin taking withdrawals from the annuity?

The Bottom Line

Annuities offer tax-deferred growth, which can result in significant long-term returns if you contribute to the annuity for a long period and wait to withdraw funds until retirement. You get peace of mind from an annuity's guaranteed income stream, and the tax benefits of deferred annuities can amount to substantial savings. Like any investment, it's important to understand how they work before adding an annuity to your retirement portfolio.