How Annuity Plans Work and What They Cost

What an annuity plan is

An 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 stream of income — either when ready or at some point in the future. The payments continue for a set period, for the rest of your life, or both, depending on the type of annuity you choose.

Annuities are often used as a retirement income tool because they convert a sum of money into predictable payments. Unlike a savings account or investment portfolio, where the balance can fluctuate and you control how much to withdraw, an annuity locks in a payment amount that the insurance company guarantees. This trade-off — giving up access to your full balance in exchange for steady income — is the core feature that separates annuities from other retirement savings vehicles.

Key Takeaways

• An annuity is an insurance contract where you pay a sum of money upfront and receive regular payments in return, either when ready or later.
• when ready annuities begin payments within a year; deferred annuities delay payments until a date you choose, sometimes decades later.
• Fixed annuities pay the same amount each period; variable annuities tie payments to investment performance; indexed annuities link payments to a market index with a may provide minimum.
• Once you purchase an annuity and payments begin, you cannot usually get your money back as a lump sum, so the decision is difficult to reverse.
• Annuities carry fees, surrender charges if you withdraw early, and tax consequences that vary depending on whether the money funding the annuity came from a retirement account or personal savings.

when ready versus deferred annuities

The timing of when payments start divides annuities into two broad categories. An when ready annuity (also called an income annuity) begins paying you within one year of purchase, usually within a month or two. You hand over a lump sum — say $200,000 — and the insurance company starts sending you monthly checks right away. when ready annuities are most common among people who have just retired and want to convert savings into may provide income when ready.

A deferred annuity delays payments until a future date you specify. You might buy a deferred annuity at age 55 and tell the insurance company not to start payments until age 70. During the waiting period, your money grows — either at a fixed rate set by the contract, or tied to investment performance, depending on the type. Deferred annuities appeal to people who do not need income right now but want to lock in a payment amount years from now, or who want their money to grow before payments begin.

The longer you wait to start payments on a deferred annuity, the larger each payment will be, because the insurance company has more time to invest your money and because you have fewer years left to receive payments. This is why someone who buys a deferred annuity at 50 and waits until 75 to collect will receive higher monthly payments than someone who buys the same annuity at 60 and waits until 75.

Fixed, variable, and indexed annuities

The way your money grows and the amount you receive each period depends on the annuity type. A fixed annuity pays you a set dollar amount each period — for example, $1,500 per month — regardless of market conditions. The insurance company invests your money and keeps any gains above what it promised you. In exchange, you get certainty: you know exactly what your check will be. The downside is that fixed payments do not keep pace with inflation, so $1,500 today buys more than $1,500 will buy in 20 years.

A variable annuity ties your payments to the performance of investments you choose — typically mutual funds or similar options offered within the annuity contract. If those investments perform well, your payment increases; if they perform poorly, your payment decreases. Variable annuities offer the possibility of higher income if markets rise, but also the risk of lower income if markets fall. They also carry higher fees than fixed annuities because the insurance company must manage the investment options and provide ongoing administrative support.

An indexed annuity (also called an equity-indexed annuity) sits between fixed and variable. Your payments are tied to the performance of a market index — often the S&P 500 — but with a floor and a ceiling. The insurance company guarantees a minimum payment even if the index declines, but it also caps how much your payment can increase if the index rises sharply. Indexed annuities appeal to people who want some upside potential without the full downside risk of a variable annuity.

How much you pay and what it costs

The amount you pay for an annuity depends on your age, the type of annuity, how long you want payments to last, and current interest rates. A 65-year-old buying an when ready fixed annuity will pay more per dollar of monthly income than a 55-year-old buying the same annuity, because the 65-year-old has fewer years to collect. A person buying an annuity when interest rates are high will receive higher payments than someone buying the same annuity when rates are low, because the insurance company can earn more on its investments.

Beyond the purchase price, annuities carry ongoing costs. Fixed annuities typically have lower fees — often built into the rate the insurance company quotes you rather than charged separately. Variable annuities charge annual fees that can range from 0.5% to 3% or more of your account balance, depending on the investment options and services included. Indexed annuities charge fees that vary by product. All annuities may include surrender charges — penalties if you withdraw money beyond a small annual allowance during the first 5 to 10 years after purchase. Surrender charges can be 5% to 10% of your withdrawal, though they typically decline each year.

If you fund an annuity with money from a traditional IRA or 401(k), you do not pay income tax on the growth while the money sits in the annuity, but you pay ordinary income tax on the payments you receive. If you fund an annuity with after-tax money from a savings account, you pay tax only on the earnings portion of each payment, not on the return of your own principal. These tax rules matter because they affect how much of each payment you keep after taxes.

What happens to your money once you buy

Once you purchase an annuity and payments begin, your options are limited. You cannot straightforward withdraw your remaining balance as a lump sum the way you can with a savings account or investment account. The money belongs to the insurance company under the terms of the contract. Some annuities offer a small annual withdrawal allowance — often 10% of your account value — without penalty, but withdrawing more triggers surrender charges. After the surrender period ends (typically 5 to 10 years), you can usually withdraw without penalty, but the insurance company may still charge a fee or adjust the payment amount.

If you die before the annuity payments end, what happens to any remaining balance depends on the contract. Some annuities pay the balance to your beneficiary; others do not. Some annuities may provide a minimum number of payments regardless of when you die; others stop paying when you die. These options affect the price you pay upfront, so it is important to understand what you are choosing before you sign.

This illiquidity — the difficulty of getting your money back — is why annuity decisions are hard to reverse. Financial advisors often recommend buying an annuity only with money you are confident you will not need access to, and only after you have built an emergency fund and paid down high-interest debt.

Annuities versus other retirement income sources

Annuities are one tool among several for generating retirement income. Social Security is a form of annuity — the government pays you a may provide amount each month for life based on your earnings history. A pension from an employer works similarly: you receive a set payment each month for life. Both are backed by the government or a large employer, not an insurance company, and both have different rules about when you can start collecting and how much you receive.

An investment portfolio — stocks, bonds, mutual funds — gives you full control over your money and flexibility to withdraw as much or as little as you want each year. The trade-off is that you bear the investment risk and the risk of running out of money if you live longer than expected or markets perform poorly. An annuity shifts both of those risks to the insurance company in exchange for predictable income and less flexibility.

Some people use a combination: Social Security and a pension (if available) provide a base of may provide income, and they use savings or investments to cover additional expenses and leave a legacy. Others buy an annuity with part of their savings to cover essential expenses and keep the rest invested for flexibility and growth. There is no single right answer; the choice depends on your income needs, risk tolerance, life expectancy, and whether you value certainty or flexibility more.

Frequently Asked Questions

Can I change my mind after I buy an annuity?

Most annuities have a surrender period of 5 to 10 years during which you can withdraw money only up to a small annual allowance (often 10%) without penalty. Withdrawing more triggers a surrender charge, typically 5% to 10% of the amount withdrawn. After the surrender period ends, you can usually withdraw without penalty, though the insurance company may adjust your payment or charge a fee. Once payments begin, reversing the decision is very difficult.

What if the insurance company goes out of business?

Each state has a guaranty fund that protects annuity holders if an insurance company fails. The protection limit varies by state but is typically $250,000 per person per company. This means your annuity payments are protected up to that amount, but if your annuity is worth more, the excess may not be covered. Buying from a financially stable, highly-rated insurance company reduces this risk.

Do I pay taxes on annuity payments?

If you funded the annuity with pre-tax money from a retirement account, you pay ordinary income tax on the full payment amount. If you funded it with after-tax money, you pay tax only on the earnings portion, not on your original contribution. The insurance company will send you a 1099-R form each year showing how much is taxable. Consult a tax professional about your specific situation.

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

An annuity converts a lump sum into income payments over time. Life insurance pays a lump sum to your beneficiaries when you die. Some products, called annuities with life insurance riders, combine both features, but they are fundamentally different tools serving different purposes.

Can I buy an annuity inside a retirement account?

Yes. You can purchase an annuity using money from a traditional IRA, Roth IRA, 401(k), or other retirement account. The tax treatment of the annuity payments depends on the type of retirement account and whether the contributions were pre-tax or after-tax. Some retirement accounts have rules limiting how much of the account balance can go into an annuity, so check your plan documents or speak with your plan administrator.