What an Annuity Is and How It Works

An annuity is a contract with an insurance company that turns a lump sum of money into regular payments

You give an insurance company a sum of money — either all at once or over time — and in return, the company promises to pay you a stream of income for a set period or for the rest of your life. The insurance company invests your money and uses the returns to fund those payments. The appeal is predictability: you know roughly how much will arrive and when, which can make retirement budgeting simpler than relying on investment returns you cannot control.

Annuities come in several shapes depending on what you need. Some start paying you right away. Others let your money grow first, then begin payments later. Some payments stay the same every month; others rise with inflation. Some last a fixed number of years; others last as long as you live. The trade-off is always the same: you give up access to the full lump sum in exchange for the certainty of regular income.

Key Takeaways

• An annuity converts a lump sum into regular monthly or annual payments, either when ready or at a future date you choose.
• when ready annuities start paying you within a year; deferred annuities let your money grow for years before payments begin.
• Fixed annuities pay the same amount each period; variable annuities tie payments to investment performance, so they can go up or down.
• Annuities are irreversible — once you hand over the money, you cannot get the full lump sum back, so understand the terms before you commit.

when ready annuities start paying you right away

With an when ready annuity, you give the insurance company a lump sum, and within a year — often within a month — the payments begin. This is the simplest structure and the easiest to understand. You know the payment amount upfront because the insurance company calculates it based on your age, the lump sum you provided, how long you are expected to live, and current interest rates.

when ready annuities are popular with people who have just retired and want to convert savings into a paycheck they cannot outlive. If you have $300,000 and buy an when ready annuity at age 65, the insurance company might pay you $1,200 per month for life. That amount is locked in and does not change (in a fixed when ready annuity), so you can count on it the same way you would count on a pension.

Deferred annuities let your money grow before payments start

A deferred annuity delays the start of payments. You might buy one at age 55 and not receive a payment until age 70 or 75. During those years, your money stays with the insurance company and grows — either at a may provide rate (fixed deferred annuity) or tied to market performance (variable deferred annuity). Once the payment phase begins, you receive income the same way you would from an when ready annuity.

Deferred annuities appeal to people who are still working and do not need income yet but want to lock in a future income stream. The longer you wait to start payments, the larger each payment will be, because your initial sum has had more time to grow. This structure also lets you take advantage of tax-deferred growth — the money inside the annuity grows without triggering annual tax bills, though you will owe taxes when you withdraw.

Fixed annuities pay the same amount every period

A fixed annuity pays you a set dollar amount each month or year, no matter what happens in the markets. The insurance company guarantees the payment and absorbs the investment risk. If you buy a fixed annuity for $200,000 and it pays $800 per month, you will receive $800 every month for as long as the contract specifies — whether the stock market rises, falls, or stays flat.

The downside is that fixed payments lose buying power over time if inflation rises. A $1,000 monthly payment is worth less in 20 years than it is today. Some fixed annuities offer a cost-of-living adjustment (COLA) rider that raises your payment each year by a set percentage or tied to inflation, but this rider costs extra and lowers your starting payment.

Variable annuities tie payments to investment performance

With a variable annuity, your payment amount changes based on how the underlying investments perform. You choose how your money is invested — usually from a menu of mutual funds — and your monthly payment rises or falls depending on whether those investments gain or lose value. If your investments perform well, your payment increases. If they perform poorly, your payment decreases.

Variable annuities carry more risk than fixed annuities because you bear the investment risk, not the insurance company. However, they offer the potential for higher payments if markets perform well, and they provide some protection against inflation because payments can grow. Many variable annuities include a may provide minimum payment, so even if investments tank, you will receive at least a floor amount each month.

Annuities are largely irreversible once you commit

Once you buy an annuity and the payment phase begins, you cannot straightforward change your mind and ask for your money back. The insurance company owns the lump sum and has committed to paying you for years or decades. Some annuities allow you to withdraw a small percentage each year without penalty, and some let you name a beneficiary who receives remaining payments if you die early, but these are exceptions built into the contract.

This permanence is why annuities are a serious financial decision. You should understand the payment amount, the length of the contract, what happens if you need emergency money, and whether the payments will be enough to live on. If you think you might need access to a large sum of money, an annuity may not be the right tool. If you want a may provide income stream and do not expect to need the principal back, an annuity can provide peace of mind.

Annuities have costs that reduce your returns

Insurance companies do not offer annuities out of generosity. They charge fees for managing your money, for the may provide they provide, and for the administrative work. These costs come out of your returns or are built into the payment calculation, meaning you receive less income than you would if you invested the money yourself and took withdrawals.

Fixed annuities typically have lower fees because the insurance company's costs are simpler — they invest conservatively and pay you a set amount. Variable annuities often have higher fees because you have investment choices and the insurance company is managing more complexity. Some annuities also charge surrender fees if you withdraw money early, penalties that can be steep in the first five to ten years.

Frequently Asked Questions

Can I get my money back if I change my mind?

Most annuities have a surrender period — typically five to ten years — during which withdrawing your full balance triggers a penalty. After the surrender period ends, you can usually withdraw without penalty, though you may owe income tax on the gains. Some annuities allow penalty-free withdrawals of a small percentage each year. Read your contract to understand what flexibility you have.

What happens to my annuity if I die?

This depends on the contract terms. Some annuities stop paying when you die, and any remaining balance goes to the insurance company. Others let you name a beneficiary who receives remaining payments or a lump sum. Some offer a "period certain" option that guarantees payments for a set number of years regardless of whether you live that long. Discuss beneficiary options with the insurance company before you buy.

How is annuity income taxed?

If you bought the annuity with pre-tax money (like from a traditional IRA), your entire payment is taxable income. If you bought it with after-tax money, only the earnings portion is taxed, not your original contribution. The insurance company will send you a tax form each year showing how much of your payment is taxable. Consult a tax professional to understand your specific situation.

Can I use an annuity inside a retirement account?

Yes. You can buy an annuity inside an IRA, 401(k), or other retirement account. This is common for people who want to convert part of their retirement savings into may provide income. Be aware that annuities inside retirement accounts do not provide additional tax benefits — the account itself already offers tax deferral — so you are paying for the insurance company's may provide without the tax advantage.

What is the difference between an annuity and a pension?

A pension is a benefit your employer provides and funds; you do not pay for it upfront. An annuity is a product you buy with your own money. Both provide regular income for life, but with a pension, the employer bears the investment risk. With an annuity, you bear the risk (in a variable annuity) or the insurance company does (in a fixed annuity).