How Annuities Work: What You Buy, What You Receive, and When

An annuity is a contract between you and an insurance company where you give them money now, and they promise to pay you income later — usually for the rest of your life

You hand over a lump sum (called the principal) to an insurance company. In return, that company commits to sending you regular payments — monthly, quarterly, or annually — for a period you choose or for as long as you live. The insurance company invests your money and uses the returns to fund your payments. The longer you live, the more total money you receive. If you die before getting back what you paid in, what happens to the remaining balance depends on the type of annuity you bought.

Annuities are not the same as life insurance. Life insurance pays your beneficiaries when you die. An annuity pays you while you are alive, and the payments stop when you die (unless you chose a form that continues to a spouse or beneficiary). You buy an annuity with after-tax money or, in some cases, by rolling over retirement account funds.

Key Takeaways

• An annuity requires you to give an insurance company a sum of money in exchange for regular income payments, usually starting at a date you choose.
• Fixed annuities pay a set dollar amount each period; variable annuities tie payments to investment performance; indexed annuities track a market index but with a floor and ceiling on gains.
• You can start receiving payments when ready (when ready annuity) or at a future date (deferred annuity), and the longer you wait, the larger each payment typically becomes.
• Annuity payments are taxed as ordinary income in the year you receive them, and withdrawals before age 59½ from a deferred annuity may trigger a 10% penalty.

The three main types of annuities and how they differ

A fixed annuity pays you the same dollar amount every period for life (or your chosen period). The insurance company bears the investment risk. If you buy a fixed annuity for $100,000, the company might promise you $500 per month for life. That $500 does not change, no matter what happens in the markets. You know exactly what you will receive.

A variable annuity ties your payments to the performance of investment accounts you choose — usually mutual funds. If those investments grow, your payments grow. If they shrink, your payments shrink. You carry the investment risk. Variable annuities often come with a may provide minimum payment, but that floor is usually much lower than what you would receive if markets perform well.

An indexed annuity (also called an equity-indexed annuity) tracks a market index like the S&P 500, but with limits. The insurance company sets a floor — your payment will not drop below a certain level — and a ceiling — your gains are capped at a certain percentage. If the index rises 15% but your cap is 10%, you get 10%. If the index falls 5% but your floor is 0%, you get 0% (no loss, but no gain). You do not own the index directly; the insurance company manages the risk.

when ready annuities versus deferred annuities

An when ready annuity begins paying you within one year of purchase, usually within one to three months. You give the insurance company money, and they start sending you checks right away. when ready annuities are common for people who have just retired and want to convert a lump sum into steady income now.

A deferred annuity does not pay you when ready. You give the insurance company money today, and it grows (either at a fixed rate or tied to investments, depending on the type). At a date you choose — perhaps 10 or 20 years later — you tell the insurance company to start sending payments. The longer you wait to start payments, the larger each payment becomes, because the insurance company has had more time to grow your money. Deferred annuities are often used as long-term savings vehicles, sometimes funded by rolling over a 401(k) or IRA.

The trade-off is straightforward: when ready annuities give you income now but lock in lower payments because the insurance company has less time to invest your money. Deferred annuities let your money grow longer, so payments are higher, but you must wait to receive them.

How annuity payments are calculated

The insurance company uses three main factors to calculate your payment amount: your age when payments begin, your life expectancy (based on mortality tables), and current interest rates. Older buyers receive larger monthly payments because the insurance company expects to pay them for fewer years. A 75-year-old buying an when ready annuity receives more per month than a 65-year-old who buys the same annuity, because the 75-year-old has a shorter life expectancy.

Interest rates matter because the insurance company invests your principal. When interest rates are high, the company can earn more on your money, so it can afford to pay you more. When rates are low, payments are lower. This is why two people buying identical annuities at different times may receive very different monthly amounts.

You can also choose how your payments are structured. A life-only annuity pays you for life, and payments stop when you die — the insurance company keeps any remaining balance. A joint-and-survivor annuity continues paying your spouse or named beneficiary after you die, usually at a reduced rate. A period-certain annuity guarantees payments for a set number of years (say, 20 years), regardless of whether you are alive. If you die after 15 years, your beneficiary receives the remaining five years of payments. These options lower your monthly payment because the insurance company's obligation extends longer.

Tax treatment of annuity income

Annuity payments are taxed as ordinary income in the year you receive them. If you bought the annuity with after-tax money (not from a retirement account), part of each payment is a return of your principal (not taxed) and part is earnings (taxed). The insurance company calculates the split using an exclusion ratio based on your life expectancy at the time payments begin.

If you funded the annuity by rolling over a 401(k) or traditional IRA, the entire payment is taxed as ordinary income because the money was never taxed when it went into those accounts. If you rolled over a Roth IRA, payments are not taxed (assuming the Roth had been open for at least five years).

If you withdraw money from a deferred annuity before age 59½, you may owe a 10% early withdrawal penalty on the earnings portion, in addition to ordinary income tax. This penalty does not explore to when ready annuities or to withdrawals after age 59½. Some deferred annuities allow you to withdraw a small percentage each year (often 10%) without penalty.

Surrender charges and when you can access your money

Most deferred annuities come with a surrender charge — a fee the insurance company charges if you withdraw more than a small amount before a set date (often 5 to 10 years after purchase). The charge is usually a percentage of the withdrawal amount and decreases each year. If you surrender a $100,000 annuity in year two with a 7% surrender charge, you pay $7,000. In year five, the charge might be 4%, so you pay $4,000. After the surrender period ends, you can usually withdraw your money without penalty.

when ready annuities do not have surrender charges because you have already committed to receiving payments. You cannot withdraw the principal; you can only receive the scheduled payments. Some when ready annuities offer a refund option (if you die early, your beneficiary gets back what you paid in) or a period-certain option (payments continue to a beneficiary for a set time), but these lower your monthly payment.

Deferred annuities often allow you to withdraw a percentage of your balance each year — commonly 10% — without triggering the surrender charge. This gives you some access to your money if you face an emergency, though you still owe income tax on any earnings you withdraw.

Annuities compared to other retirement income sources

An annuity is one way to turn savings into may provide income, but it is not the only way. Social Security provides income for life, but the amount is set by your earnings history and the age you claim. A pension (if you have one) works similarly to an annuity — you receive regular payments for life — but you do not buy it; your employer funds it. Withdrawals from a 401(k) or IRA give you control over how much you take each year, but you bear the risk that your money runs out if you live a long time or markets perform poorly.

An annuity removes longevity risk — the risk of outliving your money — because payments continue for life. The trade-off is that you lose access to your principal and cannot pass a large balance to your heirs (unless you chose a survivor option, which reduces your payments). An annuity makes sense if you want predictable income and do not need to access the lump sum, or if you have already saved enough to cover emergencies and want to convert the rest into may provide payments.

Frequently Asked Questions

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

With an when ready annuity, no — once payments begin, you receive the scheduled amount for life (or your chosen period), and the principal is gone. With a deferred annuity, you can withdraw money, but you will owe a surrender charge if you withdraw more than the allowed percentage during the surrender period (usually 5 to 10 years). After the surrender period ends, you can withdraw without penalty, though you still owe income tax on earnings.

What happens to my annuity if I die before I get back what I paid in?

It depends on the type you chose. A life-only annuity stops paying, and the insurance company keeps the balance — your heirs receive nothing. A joint-and-survivor annuity continues paying your spouse or beneficiary. A period-certain annuity pays your beneficiary for the remaining may provide period. If you want your heirs to receive something, you must choose one of these options, which will lower your monthly payment.

Can I buy an annuity with money from my 401(k) or IRA?

Yes. You can roll over funds from a 401(k), traditional IRA, or Roth IRA into an annuity. The tax treatment depends on which account type you rolled from. A rollover from a traditional 401(k) or IRA means your annuity payments are fully taxable. A rollover from a Roth IRA means payments are tax-free (if the Roth had been open at least five years). You do not owe a penalty for rolling over, but you do owe a 10% penalty on early withdrawals from the annuity if you are under 59½.

Do I have to buy an annuity through my employer?

No. You can buy an annuity directly from an insurance company, or through a financial advisor or broker. If your employer offers a pension or a 401(k) with an annuity option, that is one route, but you are not required to use it. You can also shop annuities from multiple insurance companies to compare rates and terms.

What is the difference between an annuity and a life insurance policy?

Life insurance pays your beneficiaries a lump sum when you die. An annuity pays you regular income while you are alive. Life insurance protects against dying too soon; an annuity protects against living too long and running out of money. Some products combine both features, but they serve opposite purposes.