How do annuities work?

Annuities are insurance products designed to provide you with regular income—often for life. Many also have investment components that can potentially increase their value (and your income).

When you buy an annuity, typically from an insurance company, the provider invests the money with the goal of gaining value over time or generating interest, often while protecting your nest egg. Depending on the type of annuity, you can purchase it with a lump sum of money or contribute to the account over time. And with most annuities, once you buy, you enter the accumulation phase: You continue funding the annuity before payments to you begin.

When you start taking income from your annuity, you’re in the annuitization phase. The insurer will begin making regular payments to you. Depending on the kind of annuity you have, you’ll get income for either a set period or the rest of your life (like Social Security). This steady stream can help you budget and cover expenses in retirement.

Before you buy an annuity, it’s important to understand how it might affect your taxes. There are also events that can reduce the annuity’s value (and your eventual payments). For example, different annuities may have different rules for survivor benefits or for what happens if you withdraw money before the date you and the provider agreed upon. (That date will be in the annuity contract. Different annuities have different terms and conditions for withdrawals.)

Annuities with guarantees are backed by the companies that issue them, so it’s possible (if unlikely) to lose money with one. So, consider that company’s history and track record—and read (and understand) the fine print—before you buy. To check the health of an annuity provider, review its financial strength rating from one of the leading insurance company analysts, Standard & Poor’s, Moody’s, or A.M. Best.

Types of annuities

Different kinds of annuities have different characteristics. When choosing, keep in mind your goals and needs.

Fixed vs. variable vs. indexed

A fixed annuity guarantees your principal and offers a stated rate of interest during a set period.

A fixed indexed annuity provides more growth opportunity than fixed annuities, but less potential return than a variable annuity. You decide how much of your money to allocate to a fixed-rate strategy, which grows at a predetermined interest rate. The rest goes to an index-based strategy, which has the potential to grow based on how the index(es) you choose perform. (Some fixed indexed annuities may cap the interest you can earn or the percentage of the underlying index’s growth.) Essentially, this type of annuity incorporates elements of both a fixed and an indexed annuity—it protects your money from market loss, but still has potential to grow based on the performance of a market index.

A variable annuity’s value depends on the performance of the stock market. As the name implies, its gains (and your potential payout) depend on how its investments perform. If you want exposure to potential market runups, you might gravitate to variable annuities. (At the same time, unless the annuity has protection against market downturns—usually for an extra cost—you can lose money.) These products can also let you begin taking payments immediately or wait until a later date.

An indexed variable annuity pays interest based on the performance of an index—often a large group of stocks that track a portion of the market (like the S&P 500^® index of large companies listed on U.S. stock exchanges) rather than the overall market itself. Indexed annuities can provide downside risk protection from market losses but may also set a cap on what returns you receive.

Essentially, fixed annuities provide you with more certainty: You can be reasonably sure of your payments when the time comes. By contrast, variable annuities can generate higher gains but also involve more risk and uncertainty, especially when markets are volatile.

Deferred vs. immediate

• A deferred annuity is one you purchase years before you plan to retire. You can usually set up a regular contribution schedule so you can pay into the annuity over time until you’re ready to take payments.
• You typically buy an immediate annuity with a single, lump sum amount if you want to begin receiving payments right away (or at least soon).

Some retirees take money from their retirement accounts and use it to buy an immediate annuity. This way, they can begin getting the regular cash flow they need to cover essential expenses in retirement. (Retirees can also withdraw directly from a retirement plan as they need the money, but that income won’t be guaranteed.)

Are annuities taxable?

In general, part of your annuity payout will be taxable. However, the way the money is taxed depends on how you fund the annuity.

Qualified vs. nonqualified

• You fund a qualified annuity with pretax dollars. For example, if you use money from a “traditional” 401(k) or IRA to buy or add to the annuity, it’s considered qualified. The earnings and interest from the annuity are tax-deferred, but withdrawals are taxable.
• A nonqualified annuity is funded with after-tax dollars. Because it’s money you’ve already paid taxes on, you only owe taxes on any gains the annuity accumulates.
• An annuity funded with after-tax Roth dollars—whether from an IRA or workplace retirement plan—also can grow tax-deferred, but withdrawals are tax-free if you meet certain criteria.

Payments from a qualified annuity are taxable at your regular income rate when you receive them. But payments from a nonqualified annuity are treated differently: You generally owe tax only on the earnings portion of your payments. (Insurers use a formula called an “exclusion ratio” to determine how much of your payment is taxable. It compares the amount of pretax dollars used to buy the annuity with any earnings, along with your estimated life expectancy. If you live longer, your remaining payments may become fully taxable.)

Note that some annuity providers let you withdraw a small portion of your annuity’s value without a charge. (Larger withdrawals or those you make before age 59½ could result in a additional 10% tax.) If you fund an annuity with money from a Roth account (after-tax investments with potentially tax-free withdrawals), your annuity payments could also be tax-free. Ask a knowledgeable tax professional to review your situation.

Are annuities a good investment?

Whether an annuity is right for you depends on your needs and retirement goals.

In some cases, an annuity can make sense if you want regular, predictable payments to help cover expenses during retirement. Keep in mind that you don’t have to use your entire retirement account to purchase an annuity. Instead, you can use some of it on an annuity that meets your basic income needs and keep the rest in your 401(k) or other retirement account for future growth and to cover extras.

The lifetime income that annuities can offer come with trade-offs.  Annuity contracts can be complicated, and they come with exclusions, limitations, benefit reductions, and fees. It’s important to run the numbers carefully. A trusted financial professional can help you learn the details and determine whether an annuity is a good choice for you.

How do annuities pay out?

Annuities provide multiple ways for you to receive income. If you’re retiring, have savings, and need to generate income today, you can opt for an immediate annuity. If you’re still working and saving for your future, a deferred annuity allows you to contribute over the years before beginning payments in retirement. 

Many annuities offer other payment options, including:

• Life only: Annuity payments continue as long as you live.
• Joint and survivor: Payments will continue to a spouse or other beneficiary after you pass away.
• Fixed period: Your annuity payments will last for a set period, such as five, 10, or 20 years.

What happens to your annuity payments after you pass away?

Most annuities offer a standard death benefit to help provide a legacy for your loved ones:  After you die, your beneficiaries will receive either what you’d paid into the annuity (minus any withdrawals) or the annuity’s current account value, whichever is greater.

This death benefit is generally built into an annuity at no extra cost. Some annuities offer enhanced death benefits, such as an extended payout period, for an extra fee.

What’s the difference between an annuity and a 401(k)?

Both your workplace retirement plan and an annuity can be useful for your retirement future, but there are important differences between them. For example, 401(k)s are offered through employers (or organizations), though employees (or members) are responsible for funding their own accounts.

Other “defined contribution” (DC) plans include 403(b)s (available to some public school and hospital employees) and 457(b)s (government and nonprofit workers). 401(k)s and similar plans offer important tax advantages. In a traditional 401(k), you contribute pretax dollars, and the account can grow tax-deferred until you withdraw from it, typically in retirement. In a Roth 401(k), you invest after-tax dollars, but “qualified” withdrawals are tax-free later on. Another advantage: Some employers match a portion of what you put in your account to encourage you to save for your future.

Should you choose to save in an annuity instead of a 401(k)? Not necessarily. If your employer offers a 401(k) or similar plan and matches contributions, you should save at least enough there to take full advantage of the match. 

Also note that you may—or may soon—be able to access annuities through your 401(k). The plans’ cousins, 403(b)s, have allowed many of their investments to be annuitized (guarantee regular income payments in retirement) for years. Now, thanks to the SECURE Act of 2019, it’s easier for 401(k)s to offer them too.

Another plus: 401(k)s and similar defined contribution plans are portable—you can take your account with you if you leave your job. (At least for now, you’ll only be able to annuitize if you move your money to another employer that offers it—not to an IRA. But you can always tap an IRA to buy an annuity separately.)

If you don’t have access to a 401(k), IRA, or other retirement account, you may want to consider purchasing an annuity, either with a lump sum or through regular payments. 

Author details

Miranda Marquit has been covering a variety of personal finance topics for nearly two decades. Her work has appeared in a variety of outlets, including NPR, MarketWatch, Yahoo! Finance, and HuffPost, and she co-hosts a podcast at Money Talks News.

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