What an Annuity Is and How It Works

An annuity is a contract with an insurance company where you give them money now, and they pay you back in regular installments later

You hand over a lump sum or make payments to an insurance company. In return, that company promises to send you money on a schedule you choose — monthly, quarterly, yearly, or in some other pattern. The payments continue for a set number of years, for the rest of your life, or for both your life and your spouse's life, depending on the type of annuity you buy.

The insurance company invests your money while they hold it. They keep some of the investment gains as profit. You get the rest back as your regular payments, plus a portion of what your money earned. This is different from a savings account, where the bank pays you interest. With an annuity, you are trading a large amount of money today for smaller, predictable payments spread across years or decades.

Key Takeaways

• An annuity is a contract where you pay an insurance company a lump sum and receive regular payments back over time, either for a fixed period or for life.
• Fixed annuities pay the same amount each period and are less risky; variable annuities tie payments to investment performance and can fluctuate.
• You typically cannot access your money without penalties during the early years, so annuities work best for money you will not need soon.
• Annuities are often used to replace income in retirement or to may provide a stream of money for a specific purpose.

Fixed annuities versus variable annuities

A fixed annuity pays you the same dollar amount every period for as long as the contract lasts. The insurance company bears the investment risk. If their investments do poorly, they still owe you the full payment. If their investments do well, they keep the extra gain. Your payment never changes, which makes budgeting predictable but also means inflation will slowly erode what your money buys.

A variable annuity ties your payment amount to how well a pool of investments performs. You choose from a menu of investment options — usually stock and bond funds — and your payment rises or falls based on how those investments do. If the market climbs, your payment grows. If the market drops, your payment shrinks. You bear the investment risk instead of the insurance company.

Most people choose fixed annuities for retirement income because they want to know exactly what they will receive each month. Variable annuities appeal to people who believe they can pick investments that will outpace inflation and are comfortable with payment swings.

when ready annuities and deferred annuities

An when ready annuity starts paying you within a year of purchase, usually within a month or two. You hand over a lump sum — often from a pension payout, an inheritance, or retirement savings — and the payments begin almost right away. when ready annuities are straightforward: you know the payment amount before you buy, and you start receiving money quickly.

A deferred annuity sits dormant for years before it starts paying. You might buy one at age 50 and not receive payments until age 65 or 70. During the waiting period, your money grows, either at a fixed rate or tied to market performance depending on the type. Deferred annuities are often used as a retirement savings tool — you contribute over time, and the account compounds, then converts to payments later.

What happens to your money during the contract period

When you buy an annuity, you enter a contract that typically lasts several years or the rest of your life. During this period, you usually cannot withdraw your full balance without a penalty. If you need to pull out money early, the insurance company charges a surrender charge — a percentage of your withdrawal that can range from a few percent to 10 percent or more in the early years, then decreases over time.

Most annuities allow you to withdraw a small percentage each year — often 10 percent — without penalty. Some let you access money if you face a hardship like a medical emergency. But the general rule is: annuities lock your money away. This is why they work best for money you genuinely will not need for years.

The insurance company holds your money and invests it. You do not control the investments in a fixed annuity — the company does. In a variable annuity, you choose from their menu of investment options, but you cannot pick individual stocks or bonds or move your money to a different company's investments.

How much you receive and when

The amount you receive depends on three things: how much you paid in, how long the contract lasts, and current interest rates or investment performance. Insurance companies use mortality tables — data on how long people typically live — to calculate payments. A 65-year-old will receive a higher monthly payment than a 55-year-old from the same lump sum, because the company expects to pay for fewer years.

You choose the payment schedule when you buy the annuity. Common options include monthly payments for life, monthly payments for 20 years, or monthly payments for life with a may provide that if you die early, your heirs receive the remaining balance. Each choice changes the payment amount. A lifetime payment is higher if you do not care what happens to the money after you die, and lower if you want to may provide your heirs receive something.

Why people buy annuities

Annuities appeal to people who want to turn a large sum of money into a steady income stream they cannot outlive. Someone who receives a $500,000 pension payout might buy an when ready annuity to convert it into $2,500 or $3,000 per month for life, removing the risk that they will spend the money too quickly or make poor investment choices.

Retirees use annuities to cover essential expenses — rent, utilities, food — with money they know will arrive every month. They invest other savings more aggressively because they do not need those funds to be safe. Younger workers sometimes buy deferred annuities as a forced savings tool, knowing the money will grow and eventually provide retirement income.

Annuities also appeal to people who distrust their own investment decisions or do not want to manage a portfolio. The insurance company handles the investing; you receive a check.

Costs and fees you should know about

Annuities are not free. Insurance companies charge fees in several ways. A surrender charge applies if you withdraw money early. Annual fees or mortality and expense charges are deducted from your account each year — these typically range from 0.5 percent to 2 percent of your balance annually. Variable annuities often charge investment management fees on top of that, similar to mutual fund fees.

Some annuities include riders — add-ons that provide extra features like a may provide income floor, long-term care coverage, or a death benefit. Each rider costs extra. A salesperson might bundle several riders into a package, which can make the total cost substantial.

Before you buy, ask for a written breakdown of every fee. Compare the total cost across different companies. A cheaper annuity that pays slightly less per month might leave you with more money over time because you are not paying as much in fees.

Frequently Asked Questions

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

Most states require a "free look" period of 10 to 30 days after you buy an annuity. During this window, you can return it and get your money back with no penalty. After that period ends, you can still withdraw money, but you will owe a surrender charge. The charge decreases each year and usually disappears after 5 to 10 years.

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 fund typically covers up to $250,000 per person per company, though the exact amount varies by state. This is not the same as FDIC insurance for banks, but it does provide a safety net.

Are annuities taxed differently than other investments?

If you buy an annuity with after-tax money, you only pay income tax on the earnings portion of each payment, not on the return of your principal. If you buy an annuity with money from a retirement account like an IRA, the entire payment is taxed as income. Consult a tax professional about your specific situation, as rules vary based on how you funded the annuity.

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 only" payment, the annuity ends when you die and your heirs receive nothing. If you chose a "life with period certain" option — for example, life with 20 years may provide — your heirs receive the remaining payments if you die early. Some annuities include a death benefit rider that guarantees a payout to heirs.

Is an annuity the same as a pension?

A pension is a benefit your employer provides based on your years of service. An annuity is a product you buy from an insurance company. However, when a pension pays out, you often have the choice to take a lump sum and buy an annuity with it, or to receive monthly pension payments directly from your employer. The mechanics are similar, but the source and structure are different.