How Annuities Work as a Retirement Income Tool

What an annuity is and how it pays you in retirement

An annuity is a contract with an insurance company where you give them a sum of money, and they promise to pay you a regular income for a set period or for the rest of your life. You buy the annuity before or during retirement, and the insurance company takes on the risk that you will live longer than expected. Instead of managing your own investments and worrying about running out of money, you receive predictable paychecks.

The basic trade-off is straightforward: you exchange a lump sum (or a series of payments) for may provide income later. The insurance company invests your money and uses the returns, plus money from other annuity buyers, to fund the payments they owe you. You stop worrying about market swings or whether your savings will last.

Key Takeaways

• An annuity converts a lump sum into regular income payments that can last your entire life or a fixed number of years.
• You purchase an annuity from an insurance company, not from a bank or brokerage, and the insurance company bears the longevity risk.
• when ready annuities start paying you within a year of purchase, while deferred annuities let your money grow before payments begin.
• Once you buy an annuity, you typically cannot get your principal back, so this strategy works best for money you are certain you will not need as a lump sum.
• Annuity payments are taxed as ordinary income, and the tax treatment depends on whether you bought it with pre-tax or after-tax dollars.

when ready annuities versus deferred annuities

An when ready annuity is the simplest type. You hand over a lump sum to an insurance company, and they begin sending you monthly or quarterly payments within a year. This is common for people who have just retired and want to convert savings into steady income right away. If you are 65 and have $300,000 in savings, you can buy an when ready annuity and start receiving checks the next month.

A deferred annuity works differently. You give the insurance company money now, but the payments do not start until a future date you choose — perhaps 10 or 20 years from now. During that waiting period, your money grows, either at a fixed rate the insurance company guarantees or tied to market performance. Deferred annuities are often bought by people in their 50s who want to lock in income for their 80s, or by people who receive a large sum (like an inheritance or lawsuit settlement) and want to create future income without touching it yet.

Fixed annuities, variable annuities, and indexed annuities

A fixed annuity pays you the same amount every month for life or for your chosen term. The insurance company guarantees the payment amount when you buy it. This means no surprises — you know exactly what you will receive. The trade-off is that your payments do not rise with inflation, so the purchasing power of each check shrinks over time.

A variable annuity ties your payments to the performance of investments you choose — typically mutual funds. If those investments do well, your payments increase. If they perform poorly, your payments fall. Variable annuities carry more risk but offer the possibility of higher income if markets rise. They also come with higher fees because the insurance company is not guaranteeing a fixed amount.

An indexed annuity sits in the middle. Your payments are tied to the performance of a market index (like the S&P 500), but the insurance company sets a floor — your payment will not drop below a certain minimum, even if the index falls. There is usually also a cap on how much your payment can rise in a good year. Indexed annuities appeal to people who want some upside potential but also want protection against losses.

Single-life, joint-life, and period-certain payouts

When you buy an annuity, you choose how long the payments last. A single-life annuity pays you for as long as you live, then stops. This gives you the highest monthly payment because the insurance company is betting on your life expectancy. If you live longer than average, you win. If you die sooner, the insurance company keeps the remaining balance.

A joint-life annuity (also called a survivor annuity) pays you for life, and then continues paying your spouse or designated beneficiary for their lifetime. The monthly payment is lower than a single-life annuity because the insurance company expects to pay out for two lifespans. This option protects your surviving spouse from losing income.

A period-certain annuity guarantees payments for a fixed number of years — say, 10 or 20 years — regardless of whether you are alive. If you die before the period ends, your beneficiary receives the remaining payments. If you live past the period, the payments stop. This option is useful if you want to may support your heirs receive something, or if you plan to combine it with other income sources.

How annuity payments are taxed

The tax treatment of annuity payments depends on the dollars you used to buy it. If you purchased the annuity with pre-tax money (such as a rollover from a 401(k) or traditional IRA), your entire payment is taxed as ordinary income each year. If you purchased it with after-tax money (money you already paid income tax on), only the earnings portion of each payment is taxed; the part that represents your original principal is not taxed again.

Insurance companies provide a document called an exclusion ratio that tells you what portion of each payment is taxable. This ratio is based on your life expectancy at the time you bought the annuity. If you live longer than the IRS life expectancy table predicts, eventually all of your payments become taxable. If you die before that point, your beneficiary may be able to claim a loss on their taxes.

Costs, fees, and surrender charges

Annuities are not free. Fixed annuities typically have lower costs because the insurance company is straightforward guaranteeing a payment amount. Variable and indexed annuities charge annual fees that can range from 0.5% to 2% or more of your account value, depending on the features and the insurance company. These fees pay for investment management, insurance guarantees, and the company's overhead.

Many annuities also include a surrender period — a window of time (often 5 to 10 years) during which you cannot withdraw your money without paying a penalty. The penalty typically starts high (10% or more) and decreases each year. This protects the insurance company's ability to pay you the promised income. If you think you might need access to your money, a shorter surrender period or no surrender period is worth paying for.

Before buying an annuity, ask the insurance company for a detailed breakdown of all fees and charges. Some annuities are straightforward; others have layers of riders (add-on features) that each carry their own cost. Understanding the full cost helps you decide whether the may provide income is worth the price.

When an annuity makes sense and when it does not

An annuity works well if you have a large sum of money, you want predictable income you cannot outlive, and you do not expect to need that money as a lump sum. Many financial advisors suggest using an annuity for a portion of your retirement savings — perhaps 25% to 50% — to cover essential expenses like housing and food, while keeping the rest invested for flexibility and growth.

An annuity is less useful if you have a short life expectancy, you need access to your principal, you are uncomfortable locking money away, or you believe you can earn better returns by managing your own investments. Annuities also may not make sense if you already have a pension or substantial Social Security income, because you may already have enough may provide income.

The decision depends on your personal situation, your health, your other income sources, and your comfort with giving up control. There is no single right answer for everyone.

Frequently Asked Questions

Can I change my mind after I buy an annuity?

Most annuities have a surrender period during which you can withdraw your money but will pay a penalty. After the surrender period ends, you typically cannot change the terms or get your principal back. Some annuities offer a free-look period (usually 10 to 30 days) after purchase during which you can cancel and receive a full refund. Check your contract for this option.

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 company. Before buying an annuity, you can check your state's insurance department website to confirm the protection level and verify the insurance company's financial rating.

Can I use an IRA or 401(k) to buy an annuity?

Yes. You can roll over money from a traditional IRA or 401(k) into an annuity, and the transaction is not taxed. The annuity then sits inside the IRA or 401(k) wrapper, and you follow the same withdrawal rules as the original account. This is called a may have access to annuity. Annuities purchased outside a retirement account are called non-may have access to annuities and have different tax rules.

Do annuity payments increase with inflation?

Fixed annuities pay the same amount every month, so inflation erodes the purchasing power over time. Some annuities offer an inflation rider that increases your payment by a set percentage each year (often 2% to 3%), but this rider costs more upfront and reduces your initial payment. Variable and indexed annuities may increase if the underlying investments or index performs well, but there is no may provide.

What is the difference between an annuity and a pension?

A pension is a retirement plan funded and managed by your employer, and you receive payments based on your salary and years of service. An annuity is a contract you purchase from an insurance company using your own money. Both provide may provide income, but a pension is an employer benefit while an annuity is a product you buy yourself.