How Retirement Annuities Work and What They Cost

What a retirement annuity is

A retirement annuity is a contract between you and an insurance company. You give the company a lump sum of money or make regular payments to it, and in return, the company promises to pay you a steady income for a set period — often for the rest of your life. The insurance company invests your money and uses those returns, plus your contributions, to fund your payments.

The core trade-off is straightforward: you exchange a large amount of money now for predictable paychecks later. You cannot get your original money back once the contract begins, but you know exactly how much you will receive each month. This differs from a brokerage account or mutual fund, where you own the investments directly and can withdraw any amount at any time.

Annuities are sold by insurance companies, not banks or brokerages, though some financial advisors and brokers sell them on behalf of insurers. The contract itself is a legal document that spells out the payment amount, the payment schedule, what happens if you die, and any fees involved.

Key Takeaways

• A retirement annuity converts a lump sum into monthly income, usually may provide for life, in exchange for giving up access to the original money.
• You can buy an annuity with a single payment or build one over time through regular contributions, and payments can start when ready or be delayed.
• Annuities come in several types — fixed, variable, and indexed — each with different risk levels and fee structures.
• Once you begin receiving payments, you cannot reverse the contract or withdraw the remaining balance, so understanding the terms before you buy is critical.
• Annuities carry fees that can range from less than 1 percent to over 3 percent annually, depending on the type and features you choose.

How you fund a retirement annuity

You can purchase an annuity in two main ways. A single-premium annuity means you give the insurance company one large sum — say $100,000 or $500,000 — all at once. The company then begins paying you based on your age, life expectancy, and the contract terms you chose. This is common for people who have received a lump-sum pension payout or inheritance.

A flexible-premium annuity lets you make contributions over time, similar to how you would fund a savings account. You might contribute $500 a month for several years before payments to you begin. This approach works for people still working who want to build retirement income gradually.

The money you contribute is not tax-deductible in the year you pay it, unless you are funding the annuity inside a tax-deferred retirement account like a traditional IRA or 401(k). If you buy an annuity with after-tax money, you will owe income tax only on the earnings portion of each payment you receive, not on the part that represents your original contribution.

When payments start and how long they last

An when ready annuity begins paying you within one month of purchase. You hand over your money, and within 30 days, the first check arrives. This is the simplest type and usually carries the lowest fees. It is common for people already retired who want to convert savings into may provide income right away.

A deferred annuity delays payments until a date you choose — perhaps five years, ten years, or even decades later. You contribute money now, the insurance company invests it, and payments begin on your chosen start date. Deferred annuities are often used by people in their 40s or 50s who want to lock in a payment amount before they retire.

Once payments begin, the contract specifies how long they last. A life annuity pays you for as long as you live, no matter how long that is. A term-certain annuity pays for a fixed number of years — say 20 or 30 years — and then stops, even if you are still alive. Some contracts offer a combination: payments for life, but may provide for at least 10 or 15 years even if you die early.

The three main types and their risk profiles

A fixed annuity pays you a set dollar amount each month for the life of the contract. The insurance company bears the investment risk; it promises you a specific payment regardless of market performance. In exchange, your payments do not increase with inflation. If you buy a fixed annuity paying $2,000 a month, that is what you receive in year one, year ten, and year thirty, even though $2,000 buys less over time.

A variable annuity ties your payments to the performance of investment accounts you choose — typically mutual funds within the annuity. If those investments perform well, your payments increase. If they perform poorly, your payments fall. You bear the investment risk. Variable annuities typically charge higher fees than fixed ones, often 1 to 3 percent annually, because the insurance company must manage the underlying investments and provide certain guarantees.

An indexed annuity sits between the two. Your payment is tied to the performance of a stock market index, such as the S&P 500, but with a cap and a floor. If the index rises 15 percent, your payment might rise only 10 percent (the cap). If the index falls, your payment might not fall below zero (the floor). Indexed annuities appeal to people who want some upside from market gains but protection from losses. Fees are typically moderate, around 1 to 2 percent annually.

Fees and costs you will encounter

Fixed annuities often have the lowest fees, sometimes under 1 percent per year, because the insurance company is straightforward holding your money and paying you a may provide amount. However, some fixed annuities charge surrender fees if you withdraw money before a set period — often 5 to 10 years — passes. These fees can be 5 to 10 percent of the withdrawal amount.

Variable annuities are more expensive. You typically pay an annual mortality and expense (M&E) fee of 1 to 1.5 percent, plus the fees charged by the underlying mutual funds, which can add another 0.5 to 2 percent. If you add optional features — such as a may provide minimum income rider or a death benefit — you pay additional annual fees, sometimes 0.5 to 1.5 percent more. Total annual costs for a variable annuity can easily exceed 2 to 3 percent.

Indexed annuities typically charge 0.5 to 2 percent annually, though some charge no explicit annual fee and instead take a percentage of your gains. All annuities may charge fees for early withdrawal, contract changes, or transferring money to a different annuity.

What happens to your money if you die

The contract you sign specifies what happens to any remaining balance if you die before the annuity is exhausted. With a life-only annuity, payments stop when you die, and any remaining balance belongs to the insurance company. This pays the highest monthly amount because the company knows it will not have to pay your heirs.

A life with period-certain annuity guarantees payments for a minimum period — say 10 or 20 years. If you die before that period ends, your heirs receive the remaining payments. For example, if you buy a life annuity with a 10-year period-certain and die in year 7, your beneficiary receives payments for the remaining 3 years.

A joint and survivor annuity continues paying your spouse or designated beneficiary for life after you die, usually at a reduced amount. This costs more upfront because the insurance company expects to make payments for two lifetimes instead of one.

How annuities fit into retirement planning

Annuities are one tool among many for generating retirement income. They work best for people who want to eliminate the risk of running out of money and who do not need access to a large lump sum. Because you cannot reverse the contract or withdraw the principal, annuities suit people with other savings or income sources they can tap if an emergency arises.

Some people buy a small when ready annuity to cover essential expenses — rent, utilities, food — and keep other savings in investments they can access. Others use a deferred annuity to may provide income starting at age 80 or 85, when they are most likely to need it. The decision depends on your health, other assets, family situation, and how much certainty you value.

Annuities are not suitable for everyone. If you are young, healthy, and have a long life expectancy, the cost of may provide income may outweigh the benefit. If you expect to need access to your money, an annuity locks it away. If you are concerned about inflation eroding your purchasing power, a fixed annuity may not keep pace.

Frequently Asked Questions

Can I change my mind after I buy an annuity?

Once the contract is signed and the initial period (usually 10 to 30 days) ends, you cannot cancel it without penalty. If you withdraw money early, you will owe a surrender fee, which can be substantial. Some annuities allow you to exchange it for a different annuity from the same company without penalty, but this is not may provide. Read the contract carefully before you buy.

What if the insurance company goes out of business?

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

Are annuities taxed differently than other retirement accounts?

If you buy an annuity with after-tax money, you owe income tax only on the earnings portion of each payment, not on your original contribution. If you buy an annuity inside a traditional IRA or 401(k), all payments are taxed as ordinary income. If you buy an annuity inside a Roth IRA, may have access to payments are tax-free. Consult a tax professional about your specific situation.

Do I need a financial advisor to buy an annuity?

You can buy an annuity directly from an insurance company or through a broker or financial advisor. Advisors can explain options and compare products, but they typically earn a commission on the sale, which can influence their recommendation. If you work with an advisor, ask about their compensation structure upfront.