How an Annuity Turns a Lump Sum Into Monthly Retirement Paychecks

What an annuity does in retirement

An annuity is a contract with an insurance company where you give them a sum of money upfront, and they pay you a set amount each month for the rest of your life — or for a period you choose. The insurance company takes on the risk that you will live longer than expected; you get the security of a paycheck you cannot outlive. This is different from a 401(k) or IRA, where you manage the money yourself and decide when to withdraw it.

The basic trade-off is straightforward: you exchange a lump sum today for may provide income later. If you have $300,000 saved and buy an annuity at age 65, the insurance company might pay you $1,500 per month for life. You no longer own that $300,000. The insurance company owns it, invests it, and uses the returns to fund your payments.

Annuities are most useful for people who worry about running out of money in their 80s or 90s, or who want to replace a pension they lost when they changed jobs. They are less useful if you need access to the full amount for emergencies, or if you expect to die young.

Key Takeaways

• You pay an insurance company a lump sum, and they send you a fixed monthly payment for life or a set number of years.
• The payment amount depends on your age, gender, current interest rates, and how long you want the payments to last.
• Once you buy an annuity, you cannot get the original money back, so only annuitize money you are certain you will not need.
• An annuity protects you from living too long and running out of savings, but it does not protect you from inflation unless you buy a rider that increases payments over time.
• You can buy an annuity with money from a 401(k), IRA, or personal savings, though the tax treatment differs depending on the source.

How the payment amount is calculated

The insurance company uses four main factors to decide how much to pay you each month. The first is your age at the time you buy the annuity — the older you are, the higher your monthly payment, because the company expects to pay you for fewer years. A 70-year-old gets more per month than a 65-year-old from the same $300,000.

The second factor is your gender. Women typically receive lower monthly payments than men at the same age, because women have longer average life expectancy. This is legal under federal law for annuities, though some states have challenged the practice.

The third factor is current interest rates. When interest rates are high, insurance companies can earn more on the money you give them, so they can afford to pay you more each month. When rates are low, your monthly payment shrinks. This is why the same $300,000 might buy you $1,500 per month in one year and $1,200 per month in another year.

The fourth factor is the type of annuity you choose — specifically, how long you want payments to last. A single life annuity pays you for as long as you live, then stops. A joint and survivor annuity pays you and your spouse for both of your lifetimes, but the monthly amount is lower. A period certain annuity pays for a fixed number of years (say, 20 years), regardless of whether you are alive, and then stops.

The difference between when ready and deferred annuities

An when ready annuity starts paying you within a month or two of purchase. You hand over the money, and the checks begin almost right away. This is the type most people think of when they imagine turning retirement savings into a paycheck.

A deferred annuity is a contract where you pay money now but do not receive payments until later — often years later. You might buy a deferred annuity at age 55 and not start receiving payments until age 70. During the waiting period, your money grows, and your future monthly payment will be higher than it would have been if you had bought an when ready annuity at 55. Deferred annuities are sometimes used as a way to lock in a payment amount before you retire, or to grow money tax-deferred.

For most retirees, an when ready annuity is more straightforward. You know exactly when the money will start arriving and how much it will be.

What happens to your money after you buy an annuity

Once you sign the contract and hand over your money, the insurance company owns it. They invest it in bonds, mortgages, and other fixed-income securities designed to generate steady returns. Those returns, combined with the principal, fund your monthly payments. You do not choose how the money is invested, and you cannot change your mind and ask for it back.

If you die before the insurance company has paid out the full amount you gave them, what happens to the remainder depends on the type of annuity. With a single life annuity, the remaining balance stays with the insurance company — there is no inheritance. With a period certain annuity, any remaining payments go to your estate or beneficiary. With a joint and survivor annuity, payments continue to your spouse.

This is why annuities are sometimes called a "longevity insurance" product. You are betting you will live a long time; the insurance company is betting you will not. If you live longer than average, you win. If you die young, the insurance company wins and keeps the remainder.

Annuities and taxes

The tax treatment of your annuity payments depends on where the money came from. If you bought the annuity with money from a traditional IRA or 401(k), your entire monthly payment is taxed as ordinary income in the year you receive it. If you bought it with after-tax money from a savings account, only a portion of each payment is taxed — the part that represents earnings. The part that represents your original principal is not taxed again.

If you bought the annuity inside a Roth IRA, your payments are not taxed at all, because the money was already taxed when you contributed it. However, you cannot buy an annuity inside a Roth until you reach age 59½, and you must have held the Roth for at least five years.

The insurance company will send you a 1099-R form each year showing how much of your payment is taxable. You report this on your tax return. If you bought the annuity with pre-tax retirement account money, you will owe federal income tax on 100% of the payment, plus state income tax if your state has one.

Common reasons people buy annuities in retirement

Many retirees buy an annuity with a portion of their savings — not all of it — to cover essential expenses. If your Social Security and pension cover half your living costs, you might buy an annuity to cover the other half. This way, you know those bills will be paid no matter what happens to the stock market.

Others buy an annuity because they have a large lump sum from a 401(k) rollover or an inheritance and want to convert it into predictable income. A person who receives $500,000 from a parent's estate might buy an annuity with $200,000 of it and invest the rest more aggressively.

Some people buy an annuity late in retirement, around age 75 or 80, when they want to reduce the risk of managing their own investments. At that point, the monthly payment is quite high relative to the lump sum, because life expectancy is short.

Annuities are less common for people who have a strong pension, a large amount of Social Security income, or who expect to leave money to heirs. In those cases, the trade-off of giving up access to the principal is less attractive.

Inflation and annuity payments

A fixed annuity payment of $1,500 per month will still be $1,500 per month 20 years from now. This is a problem if inflation rises, because your purchasing power shrinks. A dollar buys less in 2044 than it does today.

Some insurance companies offer an inflation-adjusted annuity or cost-of-living adjustment (COLA) rider, where your monthly payment increases each year by a set percentage — often 2% or 3% — or by the actual inflation rate. This costs more upfront. Your initial monthly payment will be lower than a fixed annuity, but it will grow over time. Whether this is worth the cost depends on your age, your health, and how much inflation you expect.

For most people, a combination approach works best: use a fixed annuity to cover essential expenses that do not change much (like property taxes or insurance), and keep other savings invested in stocks or bonds to cover discretionary spending and to hedge against inflation.

Frequently Asked Questions

Can I change my mind after I buy an annuity?

No. Once the contract is signed and the money is transferred, you cannot get it back or change the terms. Some annuities have a short "free look" period — usually 10 to 30 days — during which you can cancel and receive a full refund. After that period ends, the money is locked in. This is why it is important to be certain before you buy.

What if the insurance company goes out of business?

Each state has a guaranty fund that protects annuity holders if an insurance company fails. The coverage limit varies by state but is typically $250,000 per person per company. Before buying an annuity, you can check the financial strength of the insurance company through rating agencies like A.M. Best or Moody's.

Is an annuity the same as a pension?

They are similar in that both pay you a fixed amount each month for life. The difference is that a pension is funded and managed by your employer, while an annuity is a contract you buy from an insurance company with your own money. Pensions are becoming rare; annuities are the modern way to create a pension-like income stream.

Can I buy an annuity with money from my 401(k) while I am still working?

It depends on your plan. Some 401(k) plans allow you to buy an annuity with your balance while you are still employed, but most do not. You can roll your 401(k) into an IRA and buy an annuity there, but you cannot withdraw the money until age 59½ without a penalty. Talk to your plan administrator about what is allowed.

What if I need the money for an emergency after I buy an annuity?

You cannot get it back. This is why financial advisors recommend annuitizing only the portion of your savings you are certain you will not need for emergencies or major expenses. Keep three to six months of living expenses in a liquid savings account before you buy an annuity.