What an Insured Annuity Is and How It Works

An insured annuity is an annuity contract backed by the claims-paying ability of an insurance company

An insured annuity is a contract between you and an insurance company where you give the company a lump sum of money (or make payments over time), and in return the company promises to pay you income for a set period or for the rest of your life. The word "insured" means the insurance company itself — not a separate guarantor — stands behind that promise. If you buy an annuity from Principal Financial or Fidelity, for example, those companies are the ones legally obligated to send you checks.

This is different from some other retirement products where a bank or investment firm holds your money but a separate insurance company guarantees the payments. With an insured annuity, the insurance company is both the seller and the guarantor. The strength of that company's finances matters directly to you, because their ability to pay depends on their reserves and their claims-paying rating.

Insured annuities come in several shapes. A fixed annuity pays you a set dollar amount each month. A variable annuity ties your payments to the performance of investment accounts you choose. A deferred annuity lets you invest money now and start taking payments later. An when ready annuity starts paying you within a year of purchase. You can combine these — for instance, a deferred fixed annuity lets you lock in a may provide payment rate today for income that begins in five or ten years.

Key Takeaways

• An insured annuity is sold and may provide by an insurance company, which means that company's financial strength directly affects whether you get paid.
• Fixed annuities pay the same amount each month regardless of market performance, while variable annuities tie payments to investment returns you choose.
• The insurance company's claims-paying rating (from agencies like A.M. Best or Moody's) tells you how likely they are to meet their obligations.
• Insured annuities typically charge surrender fees if you withdraw money early, and fees vary widely depending on the contract terms and the insurance company.
• You can buy an insured annuity with pre-tax money (like a rollover from a 401(k)) or after-tax money, and the tax treatment of your payments depends on which you choose.

How the insurance company's financial strength affects your payments

When you buy an insured annuity, you are betting that the insurance company will still be in business and solvent when it comes time to pay you — especially if you are buying a deferred annuity that will not start paying for years. Insurance companies are regulated by state insurance commissioners, and each state maintains a guaranty fund that protects annuity holders if an insurance company fails. However, these funds have limits — typically $250,000 per person per company per state — so they do not cover all possible losses.

Before you buy, check the insurance company's claims-paying rating from agencies like A.M. Best, Moody's, or Standard & Poor's. These ratings reflect the company's financial stability and its track record of paying claims on time. A rating of A or higher (A.M. Best uses A++, A+, A, A–) generally indicates strong financial health. You can look up ratings for free on the rating agencies' websites or ask the insurance agent selling the annuity to show you the rating in writing.

The insurance company's investment performance also matters indirectly. If the company invests the money you give them poorly, they may struggle to meet their obligations — though this is less of a concern with fixed annuities, where the company absorbs the investment risk, than with variable annuities, where you bear it.

Fixed versus variable insured annuities

A fixed insured annuity locks in a payment rate when you buy the contract. If you pay $100,000 for a fixed annuity that promises 5 percent annually, you will receive $5,000 per year for as long as the contract specifies — whether that is ten years, thirty years, or your lifetime. The insurance company keeps your money and invests it; you do not choose where it goes. The company bears the investment risk, which is why they can promise you a fixed rate. The tradeoff is that your payments do not grow if markets perform well.

A variable insured annuity lets you direct your money into investment accounts — often mutual funds — that you choose from a menu the insurance company offers. Your monthly payment rises or falls based on how those investments perform. If your accounts gain 10 percent in a year, your payment may increase; if they lose 5 percent, your payment may decrease. You bear the investment risk, but you also have the potential for higher payments if markets do well. Variable annuities typically charge higher fees than fixed annuities because the insurance company has to manage the investment options and provide ongoing administrative support.

Some insurance companies offer indexed annuities, which sit between fixed and variable. Your payment is tied to the performance of a stock market index (like the S&P 500), but the insurance company typically caps how much you can gain in a good year and guarantees a minimum return in a bad year. These contracts are complex and fees can be substantial, so read the fine print carefully.

Surrender fees and early withdrawal penalties

Most insured annuities come with a surrender period — typically five to ten years, though some run longer — during which you cannot withdraw your money without paying a penalty. The penalty is called a surrender fee or surrender charge, and it is a percentage of the amount you withdraw. A contract might charge 7 percent in year one, 6 percent in year two, declining by 1 percent each year until it reaches zero in year eight.

Surrender fees exist because the insurance company incurs costs when you buy the annuity — commissions to the agent, administrative setup, and the cost of locking in your rate. If you leave early, the company recoups those costs from you. However, surrender fees vary dramatically between companies and contracts. Some are as low as 3 percent; others exceed 10 percent. Always ask for the surrender schedule in writing before you sign.

Even after the surrender period ends, you may face other costs. If you own a variable annuity, you pay annual fees for the investment management and insurance wrapper, typically ranging from 0.5 percent to 3 percent of your account value per year. Fixed annuities usually have lower ongoing fees, but some charge administrative fees or charges for optional riders (like a may provide that your payments will not drop below a certain level).

Tax treatment of insured annuity payments

How your annuity payments are taxed depends on whether you bought the annuity with pre-tax or after-tax money. If you rolled money from a traditional 401(k) or IRA into an insured annuity, those payments are fully taxable as ordinary income in the year you receive them. If you bought the annuity with after-tax money (money you already paid income tax on), only the earnings portion of each payment is taxable; the portion that represents your original investment comes back to you tax-free.

The insurance company will send you a Form 1099-R each year showing how much you received and how much is taxable. If you are under age 59½ and you withdraw money before the annuity starts paying (during the accumulation phase), you may owe a 10 percent early withdrawal penalty on top of income tax, though some exceptions exist for disability or substantial equal periodic payments.

If you own the annuity inside a may have access to retirement account (like a traditional IRA or 401(k)), the tax rules are the same as for the account itself — withdrawals are taxable, and early withdrawals before 59½ may trigger the 10 percent penalty. If you own it in a taxable account, the tax rules described above explore.

Comparing insured annuities to other retirement income options

An insured annuity is one way to turn a lump sum into may provide income, but it is not the only way. A pension (if your employer offers one) provides similar may provide income but you do not have to buy it — your employer funds it. A Social Security benefit is another form of may provide income that adjusts for inflation, which most annuities do not. A Treasury Inflation-Protected Security (TIPS) or a bond ladder can provide predictable income without locking your money away or paying surrender fees.

The main advantage of an insured annuity is simplicity and certainty: you know exactly what you will receive each month, and you do not have to manage investments or worry about running out of money if you live a long time. The main disadvantages are the fees, the surrender charges, the loss of flexibility, and the fact that your heirs may receive nothing if you die shortly after buying the annuity (though you can buy riders that change this).

Many financial advisors suggest using annuities for only a portion of your retirement savings — enough to cover essential expenses like housing and food — and keeping the rest in investments you can access or adjust as your needs change.

What to ask before you buy an insured annuity

Before signing an annuity contract, get the following information in writing: the insurance company's claims-paying rating, the exact payment amount and schedule, the surrender fee schedule and any other fees, the investment options (if it is a variable annuity), the tax treatment of your payments, and what happens to your money if you die. Ask whether the contract includes any riders (optional add-ons) and what they cost. Request a copy of the prospectus (for variable annuities) or the product brochure (for fixed annuities) and read it, or have a financial advisor review it with you.

Do not buy an annuity on the spot. Take the contract home, read it, and think about whether it fits your situation. If an agent pressures you to decide quickly, that is a red flag. Annuities are long-term contracts, and you deserve time to understand what you are signing.

Frequently Asked Questions

What happens to my annuity if the insurance company goes out of business?

Your state's insurance guaranty fund will step in and cover your annuity payments up to a limit, typically $250,000 per person per company per state. If your annuity is worth more than that, you may lose the excess. This is why checking the insurance company's claims-paying rating before you buy is important — a highly rated company is far less likely to fail.

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

Most states allow a "free look" period of 10 to 30 days after you buy an annuity, during which you can return it and get your money back with no penalty. After that period ends, you are subject to surrender fees if you withdraw. Check your contract for the exact free look period in your state.

Do I have to take payments for life, or can I choose a shorter period?

You can choose. Common options include a set number of years (like 10 or 20 years), payments for your lifetime, or payments for your lifetime with a may provide that your beneficiary receives a minimum amount if you die early. Each option has a different payment rate, so compare them before you decide.

Can I buy an insured annuity inside an IRA or 401(k)?

Yes, you can buy an annuity inside a traditional or Roth IRA, or roll money from a 401(k) into an annuity. The tax rules are the same as for the account itself — withdrawals are taxable (or tax-free in a Roth), and early withdrawals before 59½ may trigger a 10 percent penalty. Be aware that annuities inside retirement accounts do not provide any additional tax benefit.

What is the difference between an insured annuity and an annuity sold by a bank?

Banks sometimes sell annuities, but the annuity itself is still issued and may provide by an insurance company — the bank is just the seller. The insurance company's claims-paying rating is what matters, not the bank's. Always check who the actual issuer is before you buy.