What an Annuity Is and How It Works

An annuity is a contract with an insurance company that turns a lump sum of money into regular payments over time

You give an insurance company a sum of money — either all at once or over several years — and in return, the company promises to send you payments at set intervals. Those payments might last for a fixed number of years, for the rest of your life, or until a surviving spouse passes away. The size of each payment depends on how much you put in, how long the payments will last, and current interest rates when you buy the contract.

Annuities are sold by insurance companies, not banks or brokerages, though you may buy one through a financial advisor or broker who works with insurance carriers. They are most common as a way to convert retirement savings into income you cannot outlive, or as a payout option when you receive a large settlement or inheritance.

The word "annuity" itself comes from the Latin for "year" — the idea is annual payments, though modern annuities can pay monthly, quarterly, or on other schedules.

Key Takeaways

• An annuity is a contract where you give an insurance company money and receive regular payments in return, either for a set period or for life.
• The payment amount is locked in when you buy the annuity and depends on your age, the amount you invest, and how long payments will last.
• when ready annuities start paying you within a year of purchase, while deferred annuities let your money grow before payments begin.
• Annuities offer predictable income but come with fees, surrender charges if you withdraw early, and less flexibility than keeping money in savings.
• You should understand the specific terms of any annuity contract before signing, including what happens to your money if you die before payments end.

How the money flows: what you pay in and what you receive

When you buy an annuity, you make a payment to the insurance company. This is called the principal or premium. The company then calculates how much to send you each month or year based on three main factors: your age at the time of purchase, the total amount you invested, and how long the payments will last.

The insurance company uses mortality tables — data about how long people typically live — to figure out how much it can afford to pay you each month while still making a profit. This is why annuities purchased at an older age pay more per month than those purchased at a younger age. A 75-year-old buying a life annuity will receive larger monthly checks than a 55-year-old, because the company expects to pay out for fewer years.

Once the payment amount is set, it usually stays the same for the life of the contract. Some annuities have payments that increase each year by a fixed percentage to account for inflation, but this means the starting payment will be lower. Other annuities tie payments to stock market performance, which means the amount can go up or down.

when ready annuities versus deferred annuities

An when ready annuity begins paying you within a year of purchase, usually within one to three months. You hand over a lump sum and start receiving checks shortly after. This type is common for people who have just retired or received a large settlement and want to turn that money into steady income right away.

A deferred annuity lets your money sit and grow for years before payments start. You might buy one at age 50 and not receive payments until age 70. During the growth phase, your money earns interest or investment returns depending on the type of annuity. Deferred annuities are often used as a long-term retirement savings tool, similar to how a 401(k) works, except the insurance company guarantees a minimum return rather than you choosing individual investments.

The longer you wait to start payments on a deferred annuity, the larger each payment will be, because your principal has had more time to grow and the company will pay you for fewer remaining years.

Fixed annuities, variable annuities, and indexed annuities

A fixed annuity pays you a set amount each month for the life of the contract. The insurance company bears the investment risk — it promises you a specific return regardless of what happens in the stock market. This makes fixed annuities predictable but also means your payments do not grow if the economy booms. Fixed annuities are the simplest type and carry the lowest fees.

A variable annuity lets you choose how your money is invested among a menu of options, usually mutual funds. Your payment amount changes based on how those investments perform. If the stock market rises, your payments may increase. If it falls, your payments may decrease. Variable annuities offer more growth potential but also more risk, and they typically charge higher fees because the insurance company must manage the investment options.

An indexed annuity sits between the two. Your money is tied to the performance of a stock market index like the S&P 500, but the insurance company guarantees a minimum payment even if the index drops. If the index rises, you get a portion of those gains — usually 50 to 90 percent, depending on the contract. Indexed annuities are marketed as a middle ground, but they come with complex rules about how gains are calculated and often carry higher fees than fixed annuities.

What happens to your money if you die before payments end

This depends on the type of annuity you choose. A life annuity pays you for as long as you live, but if you die before you have received back the full amount you invested, the remaining balance goes to the insurance company. This is the trade-off for may provide lifetime income — the company keeps what you did not live to collect.

A period-certain annuity guarantees payments for a fixed number of years, such as 10 or 20 years. If you die before that period ends, your beneficiary receives the remaining payments. This protects your heirs but also means the insurance company pays out less per month than it would for a life-only annuity.

A joint-and-survivor annuity continues paying a surviving spouse (or sometimes another beneficiary) after you die, usually at a reduced rate. This is common for married couples who want to may support income continues for the surviving partner. The monthly payment is lower than a life-only annuity because the company expects to pay out for longer.

Fees, surrender charges, and what they cost you

Annuities are not free to own. Fixed annuities typically charge 0.5 to 1 percent per year in administrative and insurance fees, though these are often deducted from your payment rather than billed separately. Variable annuities charge 1 to 3 percent per year or more, depending on the investment options you choose. Indexed annuities often charge 0.5 to 1.5 percent annually, plus fees for the indexing strategy itself.

Most annuities also have a surrender period, usually 5 to 10 years, during which you cannot withdraw your money without paying a penalty. If you need to access your principal during this time, the insurance company charges a surrender fee that starts high (sometimes 7 to 10 percent of your withdrawal) and decreases each year. After the surrender period ends, you can usually withdraw money without penalty, though you may lose some of the may provide income benefit.

Some annuities include riders — add-on features that cost extra but provide additional protections, such as a may provide minimum income or the ability to pass unused money to your heirs. These riders can add 0.5 to 2 percent or more to your annual costs.

When annuities make sense and when they do not

Annuities work well if you have a large sum of money and want to convert it into predictable monthly income you cannot outlive. They are especially useful if you are worried about running out of money in retirement or if you have already maxed out other retirement savings options like 401(k)s and IRAs.

Annuities are less useful if you need access to your money, expect to live a short life, or want flexibility to pass a large inheritance to your heirs. They are also not the right choice if you cannot afford the fees or if you are buying one with money you may need in the next 5 to 10 years.

Before buying an annuity, compare the may provide payment amount to what you could earn by keeping the money in a savings account or low-cost investments. Ask the insurance company or broker to show you in writing exactly what you will receive each month, what happens if you die, what fees you will pay, and what happens if you need to withdraw money early. Read the contract carefully — annuity contracts are long and complex, and the details matter.

Frequently Asked Questions

Can I change my mind after I buy an annuity?

Most states allow a "free look" period of 10 to 30 days after purchase during which you can return the annuity and get your money back with no penalty. After that period ends, you are locked in. If you need to withdraw money during the surrender period, you will pay a penalty that decreases over time.

What is the difference between an annuity and a pension?

A pension is a benefit your employer provides and pays for. An annuity is a contract you buy yourself with your own money. Some people use an annuity to convert a lump-sum pension payout into monthly income, but the annuity itself is a separate product you purchase from an insurance company.

Do I have to pay taxes on annuity payments?

Yes, but the amount depends on whether you bought the annuity with pre-tax money (like a 401(k) rollover) or after-tax money. If you used pre-tax money, all payments are taxed as ordinary income. If you used after-tax money, only the earnings portion of each payment is taxed. Your insurance company will send you a tax form each year showing how much is taxable.

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. Before buying an annuity, you can check the financial strength rating of the insurance company through agencies like A.M. Best or Moody's.

Is an annuity the same as a 401(k)?

No. A 401(k) is a retirement savings account where you choose how to invest the money and can withdraw it anytime (with penalties before age 59½). An annuity is an insurance contract that converts a lump sum into may provide payments. Some people roll money from a 401(k) into an annuity after retirement to lock in income.