What is an annuity?
June 20, 2023 8 min read
When planning for retirement, you may come across an option called an annuity. An annuity is a legal insurance contract between an individual and a company that can help provide future income in exchange for upfront payments.
Learn more about what annuities are, how they work and their advantages and disadvantages.
- Annuities are financial products offered by insurance companies that are primarily used to provide income in retirement.
- There are three basic types of annuities: fixed, variable and indexed.
- Annuities can be either immediate or deferred, depending on when payouts begin.
- Annuities might offer reliable, tax-deferred income, but they may also come with fees or penalties for early withdrawals.
An annuity is a long-term contract with an insurance company. When you purchase an annuity, you agree to pay the insurance company a monthly premium or lump sum payment. In return, the company provides you with a single payout or a series of payouts over a specified period. The payout will equal the initial amount you paid plus interest.
You can opt for either an immediate or a deferred annuity, depending on when you want the payout to start. Immediate annuities begin paying out as soon as a lump sum is deposited. Deferred annuities start paying out at a later time that’s specified in the contract.
How do annuities work?
An annuity can help with retirement by providing a reliable source of income—and making sure you don’t outlive your savings. After purchasing an annuity contract, you later receive a specific payout amount based on the amount of money invested and the investment strategy.
Annuities work in two phases: the accumulation phase and the payout phase. The first phase is when you pay the insurance company. The second phase is when the insurance company pays you. Take a closer look at each below.
The accumulation phase
The accumulation phase is the period of time when the annuity is being funded by its owner in either a lump sum or installments.
This phase is used to build the account’s value before any payouts begin. And the money invested in this stage is tax deferred. Keep in mind that immediate annuities don’t have an accumulation phase.
The annuitization phase
Also known as the payout phase, this is the phase in which payments begin. The length of time they’re paid and the number of payments can vary depending on the type of annuity and its total value. Payouts are typically equal to the initial deposit, plus interest and minus fees.
Who is involved in an annuity contract?
Four basic parties are involved in an annuity contract:
- The owner: The owner purchases the annuity, pays the premiums and has the option to surrender the annuity. They would also name beneficiaries and be responsible for paying any taxes.
- The annuitant: Typically the same as the owner, the annuitant receives the annuity payments, and their age is used to calculate the benefits of the annuity.
- The beneficiary: The beneficiary receives any death benefit.
- The insurance company: The insurance company drafts the annuity contract, collects premium payments and provides annuity payouts.
Types of annuities
There are three basic types of annuities: fixed, variable and indexed. Annuity owners can also typically choose between an immediate or a deferred annuity. With an immediate annuity, payments begin as soon as the account is funded. Deferred annuities begin paying out on a set future date.
A fixed annuity offers a guaranteed payout amount with minimum interest rates as the account grows. It provides a predictable stream of income over a specific period of time, such as 25 years. Fixed annuities may offer lower returns compared to other types of retirement accounts.
A variable annuity can offer a higher return than other retirement accounts, but it may have more risk. It works like a tax-deferred investment account. Generally, investment options can include a combination of mutual funds consisting of a variety of stocks, bonds and money market accounts.
Unlike fixed annuities, your payout will vary depending on the rate of return on your investments.
Indexed annuity returns typically offer moderate risk and returns. They’re tied to an index, such as the S&P 500. In other words, your payout will vary depending on the index performance. This type of annuity isn’t as predictable as a fixed annuity, but it isn’t tied to the rate of return on specific investments like a variable annuity.
Here’s a comparison of the different annuities:
Costs associated with annuities
Like other retirement accounts, an annuity may be subject to early withdrawal penalties. The IRS charges a 10% tax penalty for taking funds out of the account if the annuitant is under the age of 59 1/2 unless there’s a qualifying exception. But that’s not the only potential cost to consider.
An annuity surrender period is a set amount of time that an individual must wait before selling or withdrawing funds from their annuity. Otherwise, they may have to pay a penalty called a surrender charge.
The surrender period is typically about six to eight years, starting after you purchase the annuity. If you sell or withdraw from your annuity during this period, you’ll be charged a sales tax. Keep in mind that some companies allow annuitants to withdraw up to 10% of their account’s value before they’re charged a surrender fee.
Riders are additional protections attached to an annuity contract. Living riders benefit the annuity holder while the owner is alive, and a death benefit rider protects the benefits of the annuity holder after death.
Here’s an example of a living rider: Instead of providing income after a certain age listed in the contract, a rider may be attached, allowing you to begin receiving payments before that age when needed.
The death benefit rider means if you pass before the annuity has paid all the premium payments, those payments will pass on to your beneficiaries or estate.
Some companies may provide riders free of cost, but most riders have additional fees. So it’s important to understand what riders are before purchasing them.
Like most financial products, there can be a variety of fees associated with purchasing an annuity. Typically, fees aren’t paid upfront. Instead, the company will deduct them from earnings. These fees can add up and have a direct impact on payments received.
Fees can include commissions, administration fees and maintenance fees, which can be recurring. It can help to take a look and understand all fees before agreeing to anything.
Annuity funds are usually tax deferred, meaning you won’t have to pay taxes until you start withdrawing. But any payouts you receive from the annuity are subject to income tax. And the money you contribute typically won’t reduce your taxable income, unlike other retirement account options.
Pros and cons of annuities
Annuities, like any financial product, have both benefits and drawbacks. The key is to understand what they are so you can make an educated decision based on your own circumstances.
Pros of annuities
- Reliable income stream: Annuities can offer regular income to supplement Social Security and retirement plans.
- Tax deferred: Earnings on annuities are tax deferred.
- Death benefits: Annuities might offer the option to include death benefits through a rider, so your beneficiaries will receive any remaining payments after you pass.
- No limits on contributions: Unlike some retirement accounts, annuities usually don’t have limits on how much you can contribute.
Cons of annuities
- Fees: Annuities can come with high fees. Fees may vary by annuity type and insurance company.
- Higher tax rates: When you do withdraw money from the annuity, it’ll be taxed at current income tax rates—which may be higher than long-term capital gains rates. There’s also a tax penalty for withdrawing money before age 59 1/2.
- Not liquid: Taking money from an annuity before you’ve reached the predetermined age can come with high fees, which can cut into any payouts.
- Decreased value with inflation: Annuity payouts are typically fixed—meaning the payments may not increase alongside inflation and could lead to less value and purchasing power over time.
Here are the answers to a few questions you may have if you’re considering an annuity:
Is there a difference between life insurance and annuities?
Yes. Life insurance provides benefits to beneficiaries after the policyholder’s death. Annuities might provide financial benefits, such as regular income to fill in the gaps from Social Security and investment income.
Who regulates annuities?
Like many financial insurance products, annuities are regulated by each individual state’s insurance commission, which sees that insurance companies follow the regulations that protect against fraudulent practices.
In conjunction with oversight from state agencies, variable annuities are also regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) at the federal level.
When should I buy an annuity?
The best time to purchase an annuity can vary depending on your financial circumstances and goals for retirement. Talking to a financial expert can help you make the best decision for your situation.
Annuities in a nutshell
Under the right circumstances, annuities may be a beneficial part of a retirement plan. Since they offer a variety of options and can be tailored to meet specific financial goals, they can be used to provide a reliable source of income that can last a lifetime.
As with any type of financial plan, understanding how annuities work is an important step in planning for the future. To see whether annuities are the right fit for your retirement plan, it might help to meet with a financial expert and learn how much income you need to retire.