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 your payments. The trade-off is that you give up access to the full amount upfront in exchange for predictable income you cannot outlive (in most cases).

Annuities are sold by insurance companies, not banks or brokerages, though you may buy one through a financial advisor or broker who works with insurers. They are regulated by state insurance commissioners, not the Securities and Exchange Commission, which means the rules and protections differ from stocks or bonds.

Key Takeaways

• An annuity converts a lump sum into regular monthly or annual payments, either for a fixed number of years or for your entire life.
• You purchase an annuity from an insurance company, and the company invests your money to fund the payments it owes you.
• The main types are when ready annuities (payments start right away), deferred annuities (payments start later), fixed annuities (payment amount stays the same), and variable annuities (payment amount changes based on investment performance).
• Annuities have fees, surrender charges if you withdraw early, and tax consequences that vary depending on whether you fund them with pre-tax or after-tax money.
• An annuity is permanent — once you buy one, you cannot undo the contract, so understanding the terms before you commit is essential.

when ready annuities start paying you right away

With an when ready annuity, you hand over a lump sum to the insurance company, and within a month or two, the company begins sending you monthly or annual payments. This type is common for people who have just retired, received a settlement, or inherited money and want to convert it into steady income when ready.

The payment amount is locked in based on your age, the size of your initial payment, current interest rates, and how long you want the payments to last. If you choose payments for life, the company calculates how much to send you each month based on how long it expects you to live. If you choose a fixed term — say, 20 years — the payments are higher because the company knows exactly when its obligation ends.

Deferred annuities delay payments until a date you choose

A deferred annuity is a contract where you contribute money now but do not receive payments until a future date — often years or decades later. You might buy a deferred annuity in your 50s and arrange for payments to start at age 70, for example. During the waiting period, your money grows, either at a fixed rate (in a fixed deferred annuity) or tied to market performance (in a variable deferred annuity).

Deferred annuities are often used as a retirement savings tool because they offer tax-deferred growth — you do not pay income tax on the earnings until you start withdrawing money. However, if you withdraw money before a set date (usually age 59½), you may face a surrender charge from the insurance company and a 10 percent tax penalty from the IRS, in addition to regular income tax on the earnings.

Fixed annuities pay the same amount every period; variable annuities fluctuate

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. Your payment might be $2,000 per month for life, and it stays $2,000 every month. Some fixed annuities include a cost-of-living adjustment (COLA) that increases your payment by a small percentage each year to account for inflation, though this raises the starting payment amount.

A variable annuity ties your payment amount to the performance of investments you choose — typically mutual funds within the annuity contract. If those investments perform well, your payment increases. If they perform poorly, your payment decreases. Variable annuities shift investment risk to you, but they offer the potential for higher payments if markets rise. They also carry higher fees than fixed annuities because the insurance company must manage the underlying investment options.

Annuities have costs that reduce your return

Insurance companies charge fees to manage and administer annuities. A fixed annuity might have annual administrative fees of 0.5 to 1 percent of your account value, though many fixed annuities do not charge explicit annual fees — the insurer builds costs into the interest rate it credits to your account. Variable annuities typically charge 1 to 3 percent per year in combined fees, including the cost of managing the underlying investments and the insurance wrapper.

If you buy a deferred annuity and withdraw money before the surrender period ends — typically 5 to 10 years — the insurance company charges a surrender fee, which can range from 1 to 10 percent of the withdrawal amount, depending on how early you withdraw. This fee is separate from taxes and penalties. Some annuities also charge a fee if you want to add a rider — an add-on that provides extra benefits, such as a may provide minimum income or a death benefit for your heirs.

Tax treatment depends on whether you use pre-tax or after-tax money

If you fund an annuity with money from a traditional IRA or 401(k) — money you have not yet paid income tax on — the annuity grows tax-deferred, and you pay ordinary income tax on the full amount of each payment when you receive it. If you fund an annuity with after-tax money (money you already paid income tax on), you pay income tax only on the earnings portion of each payment, not on the return of your original contribution.

If you are under age 59½ and withdraw money from a deferred annuity funded with pre-tax money, you owe a 10 percent IRS penalty on the earnings portion, in addition to regular income tax and any surrender charge from the insurance company. This penalty does not explore if you are 59½ or older, or if you meet certain other IRS exceptions (such as disability or a series of substantially equal payments).

You cannot easily undo an annuity once you buy it

An annuity is a permanent contract. Once you hand over your money and the contract is in force, you cannot straightforward change your mind and get all your money back without consequences. If you are still in the surrender period and withdraw the full amount, you pay the surrender charge. If you want to stop receiving payments and access the remaining balance, the insurance company may not allow it, or may allow it only at a steep cost.

Some annuities include a free withdrawal provision that lets you withdraw a small percentage (often 10 percent) of your account value each year without a surrender charge. Read the contract carefully to understand what happens if your circumstances change and you need access to your money. This is why financial advisors recommend buying an annuity only with money you are confident you will not need for other purposes.

Frequently Asked Questions

What is the difference between an annuity and a pension?

A pension is a benefit your employer provides and funds; you do not buy it. An annuity is a contract you purchase from an insurance company using your own money. Some people use an annuity to create a pension-like income stream in retirement, but the two are separate products with different sources and rules.

Can I buy an annuity inside a retirement account like an IRA?

Yes. You can purchase an annuity within a traditional IRA, Roth IRA, or 401(k). The tax treatment depends on the account type and the annuity type. Consult a tax professional or financial advisor before doing this, because annuities inside retirement accounts have different rules and may not offer the same tax advantages as annuities outside retirement accounts.

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. The protection limit varies by state but is typically $250,000 per person per insurer. This is a safety net, not a may provide of full recovery, so the financial strength of the insurance company matters when you buy.

Can I leave my annuity to my heirs?

It depends on the type of annuity and the options you chose. If you selected a life annuity with no survivor benefit, payments stop when you die and your heirs receive nothing. If you added a death benefit rider or chose a period-certain option (payments for a set number of years), your heirs may receive remaining payments or a lump sum. Review your contract to see what passes to your beneficiaries.

Is an annuity a good investment?

Whether an annuity makes sense depends on your age, health, income needs, and how much may provide income you already have from Social Security or pensions. Annuities are tools for converting savings into predictable income, not investments meant to grow wealth. A financial advisor can help you decide whether an annuity fits your situation.