How Annuities Work: What You're Buying and What Happens to Your Money

An annuity is a contract with an insurance company where you give them a lump sum or make payments over time, and they promise to pay you money back — either when ready, later, or for the rest of your life.

The insurance company invests your money and uses the returns to fund your payments. You choose when the payouts start, how long they last, and whether they go to a beneficiary after you die. The trade-off is that once you sign the contract, you typically cannot get your full principal back, and you pay fees to the insurance company for taking on the risk of paying you for decades.

Annuities are sold by insurance companies, not banks or brokerages, though brokers can sell them on commission. They are not government-backed like Social Security, and they are not the same as a pension — you own the contract, but the insurance company owns the obligation to pay you.

Key Takeaways

• An annuity is an insurance contract where you pay money upfront and receive scheduled payments in return, with terms that vary widely by product type.
• You can structure payouts to last a set number of years, for your lifetime, or for both your lifetime and a surviving spouse's lifetime.
• Annuities charge fees for administration, insurance risk, and investment management, which reduce the amount you ultimately receive.
• Once you buy an annuity and the payout phase begins, you cannot reverse the decision or recover your principal in most cases.

The three main types: when ready, deferred, and variable

An when ready annuity is the simplest: you hand over a sum of money (often $100,000 or more) and the insurance company starts paying you within a month or so. You choose how long the payments last — for a set period like 10 years, for your lifetime, or for your lifetime plus a survivor's lifetime. The longer the insurance company must pay, the smaller each monthly check.

A deferred annuity is a waiting contract. You pay money now, but the payouts do not start until a date you choose — often years or decades later. During the waiting period, your money grows (either at a fixed rate set by the insurance company, or tied to market performance). When you reach the payout date, the contract converts to an when ready annuity and payments begin. Deferred annuities are often bought by people in their 40s or 50s who want may provide income later in retirement.

A variable annuity ties your payouts to the performance of investment accounts you choose — typically mutual funds. If the market rises, your payments may rise. If it falls, your payments may fall. Variable annuities carry more risk than fixed annuities but offer the possibility of higher returns. They also charge higher fees because the insurance company must manage the underlying investments.

Fixed annuities lock in a rate; indexed annuities tie returns to a market index

A fixed annuity pays you a rate of return set by the insurance company when you buy the contract. That rate is may provide for a set period — often 3, 5, 7, or 10 years. After that period ends, the company offers a new rate, which may be higher or lower. Your principal is protected: the insurance company absorbs market losses. The trade-off is that your returns are modest, usually 2 to 4 percent annually in recent years, and you give up any chance of higher gains if the market rises sharply.

An indexed annuity (also called an equity-indexed annuity) splits the difference. Your return is tied to the performance of a market index like the S&P 500, but with a cap and a floor. If the index rises 10 percent, you might earn 6 percent (the cap). If the index falls 5 percent, you might earn 0 percent (the floor). Indexed annuities protect you from losses but limit your upside. They are more complex than fixed annuities and carry higher fees.

How payout options change what you receive each month

When your annuity enters the payout phase, you choose how the money flows. A life-only payout gives you the highest monthly check because the insurance company only has to pay you until you die — no survivor gets anything. If you die at 75, the remaining money stays with the insurance company.

A life with period certain payout guarantees payments for your lifetime, but if you die before a set period (often 10 or 20 years), your beneficiary receives the remaining payments. This option pays less per month than life-only because the insurance company may have to pay your estate after you die.

A joint and survivor payout continues for both your lifetime and your spouse's lifetime. The monthly check is lower than life-only because the insurance company expects to pay for two lives. You can choose whether your survivor receives the full amount or a reduced amount (often 50 or 75 percent) after you die.

A period certain payout (also called a term certain) pays for a fixed number of years — say, 10 or 20 — regardless of whether you are alive. If you die in year 3, your beneficiary receives the remaining 7 years of payments. This option pays the least per month because the insurance company's obligation is predictable and limited.

Fees and surrender charges reduce your returns

Annuities are not free. Most charge an annual management fee (often 0.5 to 1.5 percent of your balance per year for fixed annuities, higher for variable annuities). Some charge a surrender charge — a penalty if you withdraw money or cancel the contract within a set period, usually 5 to 10 years. Surrender charges can be 5 to 10 percent of your withdrawal amount and decline each year you hold the contract.

Variable annuities often charge mortality and expense risk fees (the cost of the insurance may provide) plus investment management fees for the underlying mutual funds. These can total 1 to 3 percent annually. Indexed annuities charge fees that are often hidden in the cap rate — if the index rises 10 percent but your cap is 6 percent, the insurance company is keeping the difference.

Some annuities include riders — add-ons that cost extra but provide features like a may provide minimum income, long-term care benefits, or a death benefit. A rider might cost 0.25 to 1 percent per year on top of the base fee.

Tax treatment: ordinary income, not capital gains

Money you withdraw from an annuity is taxed as ordinary income, not as capital gains, even if the annuity earned money through stock market gains. This means your tax rate is higher than it would be for long-term capital gains (which are taxed at 0, 15, or 20 percent depending on income, versus ordinary income rates up to 37 percent).

If you buy an annuity with pre-tax money (for example, from a rollover of a traditional IRA), all your withdrawals are taxed as ordinary income. If you buy an annuity with after-tax money, only the earnings portion is taxed; your principal comes out tax-free. The insurance company tracks this using an exclusion ratio that determines what portion of each payment is taxable.

If you withdraw money before age 59½ from an annuity you bought outside a retirement account, you may owe a 10 percent early withdrawal penalty on the earnings portion, plus ordinary income tax. Annuities bought inside a retirement account (like an IRA) follow the retirement account's withdrawal rules, not the annuity's.

When you might consider an annuity versus other retirement income sources

An annuity converts a lump sum into a predictable stream of income for life. This appeals to people who worry about outliving their savings, want to remove investment decisions from their hands, or want a portion of their retirement income to be may provide. An when ready annuity bought at 65 might pay you 4 to 5 percent of your principal annually for life, depending on interest rates and your age.

The downside is loss of control and flexibility. Once you buy an when ready annuity, you cannot change your mind, access your principal, or leave a large inheritance (unless you choose a survivor option, which reduces your monthly payment). If you die soon after buying, your heirs may receive far less than you paid. Annuities also do not keep pace with inflation — a $2,000 monthly payment stays $2,000 even as prices rise, unless you buy an inflation-adjusted rider (which costs more and pays less initially).

Alternatives include managing your own portfolio and withdrawing a percentage each year (like the 4 percent rule), buying a pension through a deferred income annuity (which starts payments many years later), or combining Social Security with part-time work or investment income. Some people buy a small when ready annuity to cover essential expenses and keep the rest of their savings invested for growth and flexibility.

Frequently Asked Questions

Can I get my money back if I change my mind after buying an annuity?

Most states require a "free look" period of 10 to 30 days after you buy an annuity, during which you can cancel and get your full money back. After that period ends, you can withdraw money but will owe a surrender charge, which typically declines over 5 to 10 years. Once the payout phase begins, you cannot recover your principal in most cases.

What happens to my annuity if the insurance company fails?

Each state has a guaranty fund that protects annuity holders if an insurance company becomes insolvent. Coverage limits vary by state but typically range from $100,000 to $500,000 per person per company. This protection covers the insurance company's obligation to pay you, not the investment performance of the annuity itself.

Is an annuity the same as a pension?

No. A pension is an employer-funded benefit that pays you for life based on your salary and years of service. An annuity is a contract you buy yourself with your own money. Both provide lifetime income, but pensions are funded by employers and annuities are funded by you.

Do I have to buy an annuity inside a retirement account?

No. You can buy an annuity with money outside any retirement account, though you will owe taxes on the earnings portion of your withdrawals. Some people buy annuities inside IRAs or 401(k)s, but this is less common because retirement accounts already offer tax deferral, making the annuity's tax benefits redundant.

What is a deferred income annuity, and how is it different from a deferred annuity?

A deferred income annuity (DIA) is a specific type of deferred annuity designed to start payments at a future date you choose — often age 75 or 80. You pay a lump sum now, and the insurance company invests it. At your chosen date, it converts to an when ready annuity and payments begin. DIAs are often used to create may provide income later in retirement when you may have depleted other savings.