How a Retirement Annuity Converts Your Savings Into Monthly Payments

What a retirement annuity does

A retirement annuity is a contract between you and an insurance company. You give the company a lump sum of money (or make payments over time), and in return, the company promises to send you regular payments for the rest of your life, or for a set number of years you choose. The insurance company takes on the risk that you will live longer than expected; you get the security of knowing exactly how much money will arrive each month.

The amount of your monthly payment depends on three things: how much money you put in, your age when payments start, and current interest rates. A 65-year-old who puts in $100,000 will receive a different monthly amount than a 75-year-old with the same $100,000, because the insurance company expects to pay out over fewer years.

Key Takeaways

• You pay a lump sum to an insurance company, and they send you a fixed monthly payment for life or a chosen period, starting when ready or at a future date.
• The payment amount is locked in when you buy the annuity and does not change, even if inflation rises or interest rates fall.
• when ready annuities begin payments within a year; deferred annuities delay payments until a date you select, sometimes decades later.
• Once you buy an annuity, you cannot get your money back as a lump sum, though some types offer survivor benefits or refund options that reduce your monthly payment.
• Annuities are taxed differently depending on whether you buy them with pre-tax retirement account money or after-tax savings.

when ready annuities versus deferred annuities

An when ready annuity starts sending you payments within one year of purchase, usually within a few months. You hand over a sum of money—say $200,000—and the insurance company begins paying you a monthly amount right away. This type is common for people who have just retired and want to convert savings into may provide income when ready.

A deferred annuity delays payments until a future date you choose. You might buy one at age 55 and tell the insurance company to start payments at age 70. During those 15 years, your money sits with the insurance company and grows (either at a fixed rate or tied to market performance, depending on the type). When payments finally begin, they are larger than they would have been if you had bought an when ready annuity at 55, because the insurance company had more time to invest your money.

Some people use deferred annuities as a way to may provide income later while keeping other savings available now. Others buy them inside retirement accounts like IRAs, where the tax rules around annuities work differently.

How the payment amount is calculated

The insurance company uses three main inputs to calculate your monthly payment: your age, the amount you invest, and the current interest rate environment. A higher interest rate means the insurance company expects better returns on its investments, so it can afford to pay you more each month. When interest rates are low, monthly payments are lower.

Your gender also affects the calculation in most states. Women receive lower monthly payments than men at the same age with the same investment, because women have a longer average life expectancy. Some states have rules about this, so the exact treatment varies by location and insurance company.

Once you lock in a payment amount, it does not change. If you buy a $200,000 when ready annuity at age 65 and receive $900 per month, you will receive $900 per month for the rest of your life (or for the period you chose). Inflation will erode the purchasing power of that $900 over time, but the dollar amount stays the same unless you bought an inflation-adjusted annuity, which costs more upfront and pays less initially.

What happens to your money after you buy

Once you hand over your money and the contract is signed, the insurance company owns it. The company pools your money with money from thousands of other annuity buyers and invests it in bonds, mortgages, and other stable assets. The returns from those investments, combined with the company's own capital, fund the monthly payments it sends you.

You do not own the underlying investments. You own only the right to receive the monthly payment the contract promises. This is different from owning a mutual fund or a brokerage account, where you own the actual securities and can sell them whenever you want.

If the insurance company invests poorly or faces financial trouble, your payments are protected by state insurance guaranty funds, which exist in every state. These funds cover annuity payments up to a limit (usually $250,000 per person per company, though the exact amount varies by state). This protection is one reason annuities are considered safer than keeping money in a brokerage account during a market crash.

Single-life, joint-life, and period-certain options

When you buy an annuity, you choose how long the insurance company will make payments. A single-life annuity pays you for as long as you live, then stops. When you die, your beneficiaries receive nothing (unless you chose a refund option). This option produces the highest monthly payment because the insurance company's obligation ends when you do.

A joint-life annuity (also called a joint-and-survivor annuity) continues paying your spouse or another beneficiary for their lifetime after you die. Your monthly payment is lower than a single-life annuity because the insurance company expects to make payments for longer. You choose what percentage of your payment your survivor receives—often 50%, 75%, or 100%.

A period-certain annuity guarantees payments for a set number of years, such as 10 or 20 years, regardless of whether you are alive. If you die after 7 years of a 20-year period-certain annuity, your beneficiaries receive the remaining 13 years of payments. If you live past the period, payments stop. This option is less common for retirement income because it does not protect you against living a very long life.

Some annuities combine these: a joint-life annuity with a 10-year period-certain means payments continue to your spouse after you die, but if you both die within 10 years, the remaining payments go to your estate.

Tax treatment of annuity payments

How much of your annuity payment is taxable depends on whether you bought the annuity with pre-tax money or after-tax money. If you bought an when ready annuity with money from a traditional IRA or 401(k), your entire monthly payment is taxable income in the year you receive it. The insurance company will send you a 1099-R form each January showing the amount.

If you bought an annuity with after-tax savings (money you already paid income tax on), only part of each payment is taxable. The IRS uses an exclusion ratio to determine what portion of your payment represents a return of your own money (not taxable) versus investment gains (taxable). This ratio is calculated based on your age, the amount you invested, and life expectancy tables. A financial professional or tax preparer can help you figure out the exact amount.

Annuities bought inside a Roth IRA work differently: if you have held the Roth for at least five years and are at least 59½, your payments are tax-free. If you withdraw before meeting these conditions, the earnings portion is taxable and may face a 10% penalty.

Costs, fees, and surrender periods

when ready annuities typically have no ongoing fees or surrender charges. You pay the insurance company a lump sum, and they send you payments. The insurance company's profit comes from the spread between what it earns on your money and what it pays you.

Some annuities, particularly deferred annuities, charge annual fees or have surrender periods—windows of time during which you cannot withdraw your money without paying a penalty. If you buy a deferred annuity and try to withdraw before the surrender period ends (often 5 to 10 years), you may lose 5% to 10% of your withdrawal. Always read the contract to understand what fees explore and when you can access your money without penalty.

Variable annuities, which tie your payments to market performance, charge higher fees than fixed annuities because the insurance company must manage investments. Indexed annuities, which tie payments to a stock market index, fall somewhere in between.

Frequently Asked Questions

Can I change my mind after buying an annuity?

Most when ready annuities cannot be cancelled or reversed once the contract is signed. Your money is gone, and you receive the monthly payments for life. Some contracts include a short free-look period (usually 10 to 30 days) during which you can return the annuity and get your money back. Deferred annuities often have surrender periods; if you withdraw during this time, you pay a penalty.

What if I need a large sum of money after buying an annuity?

With a standard when ready annuity, you cannot get a lump sum. You receive only the monthly payments. Some annuities offer riders that let you withdraw a percentage of your remaining balance in emergencies, but these cost more upfront and reduce your monthly payment. If you think you might need access to large amounts of money, an annuity may not be the right choice.

Do annuities protect me from inflation?

A standard annuity pays the same dollar amount every month forever, so inflation erodes its purchasing power over time. You can buy an inflation-adjusted annuity that increases your payment by a set percentage each year (often 2% or 3%), but this costs more upfront and your initial payment is lower. Without this rider, a $1,000 monthly payment in 2024 will buy much less in 2044.

What happens to my annuity if the insurance company fails?

Each state has an insurance guaranty fund that protects annuity holders if an insurance company becomes insolvent. These funds typically cover up to $250,000 per person per company, though the exact limit varies by state. This protection is automatic; you do not need to do anything. Buying from a company with a strong financial rating (A or higher from rating agencies like AM Best) reduces the risk further.

Can I use an annuity inside a retirement account?

Yes. You can buy an when ready or deferred annuity inside a traditional IRA, Roth IRA, or 401(k). The tax rules are the same as for annuities outside retirement accounts, except that money inside a traditional IRA or 401(k) is already pre-tax, so your annuity payments are fully taxable. Roth annuities follow Roth rules: payments are tax-free if you meet the age and holding-period requirements.