What an Annuity Is and How It Works

An annuity is a contract with an insurance company where you give them money now, and they pay you back in regular installments over time

You buy an annuity by paying a lump sum or a series of payments to an insurance company. In return, the company promises to send you money at set intervals — monthly, quarterly, or annually — for a period you choose or for the rest of your life. The amount you receive depends on how much you paid in, your age, current interest rates, and the type of annuity you select.

Annuities are not the same as savings accounts or bonds. With a savings account, you keep control of your money and can withdraw it whenever you want. With an annuity, you trade that flexibility for a may provide income stream. Once you sign the contract and hand over your money, you cannot get the full amount back — you receive it in pieces according to the schedule.

Insurance companies use annuities to manage risk. They invest your money and pay you from those returns plus their own reserves. This is why annuities are sold by insurance companies, not banks, even though they function somewhat like a long-term savings product.

Key Takeaways

• An annuity is a contract where you pay an insurance company a sum of money in exchange for regular payments spread over time or for life.
• You lose access to the full lump sum once you buy an annuity, receiving money instead in scheduled installments.
• The amount of each payment depends on your age, the size of your initial payment, interest rates at the time of purchase, and the annuity type you choose.
• Annuities are sold by insurance companies and come in several varieties, each with different rules about when you can access your money and how payments work.

when ready annuities start paying you right away

With an when ready annuity, you give the insurance company a lump sum, and they begin sending you payments within a month or two. This type is straightforward: you know how much you paid in, you know roughly how much each payment will be, and you know when the payments start.

when ready annuities are often used by people who have just retired and want to convert savings into a steady income. If you are 65 years old and buy a $200,000 when ready annuity, the insurance company calculates your monthly payment based on how long they expect you to live, current interest rates, and their costs. That payment amount stays the same for life if you choose a fixed when ready annuity.

The trade-off is that you cannot change your mind. Once you buy an when ready annuity, you have committed that money to the insurance company's payment schedule. Some when ready annuities allow you to name a beneficiary who receives remaining payments if you die before the contract ends, but this typically reduces your monthly payment.

Deferred annuities delay payments until a future date you choose

A deferred annuity is a contract where you pay the insurance company now, but the payments do not start until later — sometimes years or decades later. During the waiting period, your money grows inside the annuity account. This growth is tax-deferred, meaning you do not pay income tax on the earnings until you withdraw them.

Deferred annuities appeal to people who are still working and want to set aside money for retirement without paying taxes on the growth each year. You might buy a deferred annuity at age 50 and decide that payments will begin at age 70. The insurance company invests your money during those 20 years, and the account value increases.

When the payment date arrives, you can either take a lump sum withdrawal or convert the account into an income stream. Some deferred annuities let you withdraw a small percentage each year without penalty, while others lock your money away until the start date you selected.

Fixed annuities pay the same amount every period; variable annuities fluctuate

A fixed annuity pays you a set dollar amount at each interval. The insurance company guarantees this payment regardless of market conditions. If your contract says you receive $1,500 per month, you receive $1,500 every month for life or for the term you selected. This predictability makes budgeting easier, but it also means your income does not grow if inflation rises.

A variable annuity ties your payments to the performance of investments you choose — usually mutual funds or stock and bond portfolios. If those investments perform well, your payment increases. If they perform poorly, your payment decreases. Variable annuities offer growth potential but introduce risk: you could receive less money in months when markets decline.

Fixed annuities are backed by the insurance company's promise to pay. Variable annuities shift some investment risk to you. Some variable annuities include a may provide minimum payment, which means your payment will not fall below a certain floor even if investments perform poorly, but this may provide typically costs more.

Indexed annuities tie payments to a market index like the S&P 500

An indexed annuity is a middle ground between fixed and variable. Your payment is linked to the performance of a market index — often the S&P 500 or another stock index — but with a cap and a floor. If the index rises 10 percent, you might receive a payment increase of 5 percent (the cap limits your upside). If the index falls, your payment does not decrease below a may provide minimum (the floor protects your downside).

Indexed annuities appeal to people who want some growth potential without the full risk of variable annuities. The insurance company keeps the difference between what the index earns and what they pay you, which is how they profit and how they can afford to may provide a floor.

The terms of indexed annuities vary widely between products and insurance companies. The cap, floor, and the specific index used all affect how much you ultimately receive. Reading the contract carefully is essential because these details determine whether an indexed annuity actually provides the balance you are seeking.

Annuity payments can last for a set number of years or for your entire life

When you buy an annuity, you choose how long the payments continue. A term-certain annuity pays for a fixed period — 10 years, 20 years, or 30 years, for example. Once that period ends, payments stop, even if you are still alive. If you die before the term ends, your beneficiary receives the remaining payments.

A life annuity pays for as long as you live, no matter how long that is. The insurance company calculates the payment assuming you will live to an average life expectancy for your age and gender. If you live longer, you receive more total money than you paid in. If you die sooner, the insurance company keeps the remainder.

Some annuities combine both: a life annuity with a period certain guarantees payments for a minimum number of years (say, 10 years) and then continues for life. This protects your beneficiary if you die early while still providing lifetime income if you live long.

Annuities have fees and surrender charges you should understand

Annuities are not free to own. Insurance companies charge mortality and expense fees, typically 0.5 to 1.5 percent of your account value per year, to cover the cost of guaranteeing your payments and running the product. Variable annuities often charge additional investment management fees for the mutual funds inside the contract, which can range from 0.5 to 2 percent annually.

Most annuities also include a surrender period, usually 5 to 10 years, during which you cannot withdraw your money without paying a penalty. The penalty typically starts high (10 percent of your withdrawal) and decreases each year. This is how insurance companies protect themselves against early withdrawals that would disrupt their investment strategy.

Some annuities allow you to withdraw a small percentage — often 10 percent — of your account value each year without penalty, even during the surrender period. Others offer a free look period, usually 10 to 30 days, during which you can return the annuity and get your money back if you change your mind.

Frequently Asked Questions

Is an annuity the same as a pension?

No. A pension is a benefit your employer provides and pays for. An annuity is a product you buy with your own money from an insurance company. However, some pensions work like annuities — they pay you regular income for life. The difference is who owns and funds it.

Can I withdraw money from an annuity before the payment date?

Yes, but usually with a penalty. During the surrender period, early withdrawals trigger a surrender charge that can be 5 to 10 percent of the amount you withdraw. After the surrender period ends, you can typically withdraw without penalty, though you may owe income tax on the earnings portion of your withdrawal.

What happens to my annuity if the insurance company fails?

State insurance regulators oversee insurance companies, and most states have a guaranty fund that protects annuity holders if an insurer becomes insolvent. The protection limit varies by state but is typically $250,000 per person per company. This is different from FDIC bank insurance, which covers deposits up to $250,000.

Do I pay taxes on annuity payments?

Yes. The portion of each payment that represents your original investment is not taxed, but the portion that represents earnings is taxed as ordinary income. If you bought the annuity with pre-tax money (like from a traditional IRA), the entire payment is taxed. If you bought it with after-tax money, only the earnings portion is taxed.

Can I change my mind after buying an annuity?

During the free look period — usually 10 to 30 days — you can return the annuity and receive your full payment back. After that period ends, you are locked into the contract. You can withdraw money, but surrender charges explore during the surrender period, which typically lasts 5 to 10 years.