What an Annuity Does and Why People Buy Them

An annuity converts a lump sum of money into regular payments over time

An annuity is a contract between you and an insurance company. You give the company a sum of money — either all at once or over time — and in return, the company promises to pay you a stream of income. That income can start when ready, years from now, or when you reach a certain age. The core purpose is to turn money you have today into predictable paychecks you cannot outlive.

The insurance company invests your money and uses the returns, along with your principal, to fund your payments. Because the company pools risk across many customers, it can may provide a payment amount even if you live longer than expected. That may provide is what separates an annuity from straightforward withdrawing money from a savings account on your own schedule.

Key Takeaways

• An annuity pays you a fixed or variable income stream in exchange for a lump sum or regular contributions you give to an insurance company.
• The main purpose is to create income you cannot outlive, which is useful in retirement when you want predictable money regardless of how long you live.
• Annuities can start paying you when ready (when ready annuities) or years later (deferred annuities), depending on your needs and when you buy.
• The payments you receive are taxed as ordinary income in the year you receive them, though the tax treatment of your contributions depends on whether you funded the annuity with pre-tax or after-tax dollars.

when ready annuities pay you right away

An when ready annuity begins sending you payments within a year of purchase, usually within a month or two. You hand over a lump sum — say $200,000 — and the insurance company starts writing you checks monthly, quarterly, or annually. The payment amount is locked in and does not change (in a fixed when ready annuity) or moves with market performance (in a variable when ready annuity).

People typically buy when ready annuities when they have just retired and want to convert retirement savings into may provide income right now. A widow or widower who receives a large inheritance might also use an when ready annuity to create steady income without having to manage investments. The tradeoff is that once you buy the annuity, you cannot get your principal back — the money belongs to the insurance company, and you receive only the payment stream.

Deferred annuities let you wait before payments begin

A deferred annuity is a contract where you contribute money now but do not receive payments until a future date you choose — often years or decades away. During the waiting period, your money grows either at a fixed rate (in a fixed deferred annuity) or tied to market indexes (in an indexed or variable deferred annuity). When the payout phase arrives, the annuity converts your accumulated balance into regular income, just like an when ready annuity does.

Deferred annuities appeal to people in their 40s or 50s who want to lock in may provide income for later retirement years. Because the money has decades to grow before you need it, the insurance company can offer higher monthly payments than an when ready annuity would provide for the same initial contribution. Some deferred annuities also let you withdraw a portion of your balance before the payout phase begins, though doing so often triggers a surrender charge.

Fixed annuities may provide a payment amount; variable annuities do not

A fixed annuity promises you a specific dollar amount each month or year, no matter what happens in the markets. The insurance company bears the investment risk and guarantees the return. If you buy a fixed when ready annuity for $200,000 and it promises you $1,000 per month for life, you will receive $1,000 every month for as long as you live, even if stock markets crash or interest rates fall.

A variable annuity ties your payments to the performance of investment accounts you choose — typically mutual funds or index funds. If those investments perform well, your payment increases. If they perform poorly, your payment decreases. You bear the investment risk, not the insurance company. Variable annuities appeal to people who believe they can beat the market and want the potential for higher income, but they also accept the possibility of lower income if investments underperform.

Some annuities blend the two: an indexed annuity credits your account based on the performance of a market index (like the S&P 500) but typically includes a floor — a minimum return you will receive even if the index declines. This middle ground offers more upside than a fixed annuity but more protection than a variable annuity.

Annuities solve the longevity problem in retirement

The core reason people buy annuities is to address longevity risk — the risk of living longer than your money lasts. If you retire at 65 with $500,000 and withdraw 4 percent per year, you might run out of money by age 90 if you live longer or markets perform poorly. An annuity removes that worry by guaranteeing income for life, no matter how long you live or what markets do.

This is especially valuable for people without a pension. A traditional pension from an employer pays you a may provide monthly amount for life, much like an annuity does. Most workers today do not have pensions, so an annuity can replicate that benefit. By converting a portion of retirement savings into an annuity, you create a floor of may provide income — money you know will arrive every month — and can take more risk with the rest of your savings because you know your basic expenses are covered.

Tax treatment depends on how you fund the annuity

If you buy an annuity with money from a may have access to retirement account — an IRA, 401(k), or similar plan — the entire payment you receive is taxed as ordinary income in the year you receive it. The insurance company will send you a 1099-R form each year showing how much you received.

If you buy an annuity with after-tax money (money you already paid income tax on), only a portion of each payment is taxable. The insurance company calculates an exclusion ratio that separates the return of your principal (not taxed again) from the investment earnings (taxed as ordinary income). This calculation is complex and the insurance company handles it, but the result is that you pay tax only on the gain, not the full payment.

Annuities held inside a may have access to retirement account are subject to the same withdrawal rules as the account itself. If you own an IRA annuity and withdraw money before age 59½, you typically face a 10 percent early withdrawal penalty on top of income tax, with some exceptions for disability or medical expenses.

Annuities have costs and restrictions you should understand

Insurance companies charge fees to manage annuities. A fixed annuity might have minimal visible fees because the company profits from the spread between what it earns on your money and what it pays you. A variable annuity typically charges an annual expense ratio (usually 0.5 to 2 percent per year) plus a mortality and expense fee (typically 0.5 to 1.5 percent per year) to cover the insurance may provide and administration.

Deferred annuities often include a surrender period — typically 5 to 10 years — during which you cannot withdraw your full balance without paying a penalty. If you withdraw more than a small percentage during this period, the insurance company charges a surrender charge that declines each year. After the surrender period ends, you can usually withdraw your balance without penalty, though you may still face tax consequences.

Once you begin receiving annuity payments, you cannot change your mind and get your money back. This is why annuities work best for money you are confident you will not need for other purposes. If you think you might need access to a large sum for a medical emergency or to help family members, an annuity may not be the right choice for that money.

Frequently Asked Questions

Can I change my mind after I buy an annuity?

During the surrender period (typically 5 to 10 years for deferred annuities), you can withdraw your money but will pay a surrender charge that decreases each year. After the surrender period ends, you can withdraw your balance without penalty, though you will owe income tax on any gains. Once you start receiving annuity payments, you cannot reverse the contract — the money is gone and the payments continue for life or your chosen period.

What happens to my annuity if I die?

It depends on the payout option you chose when you bought the annuity. A "life only" annuity stops paying when you die — the insurance company keeps any remaining balance. A "life with period certain" annuity continues paying your beneficiary for a set number of years (like 10 or 20 years) if you die before that period ends. A "joint and survivor" annuity continues paying your spouse for life after you die. These options reduce your monthly payment because the insurance company expects to pay longer.

Is an annuity the same as a pension?

An annuity and a pension both provide may provide lifetime income, but a pension is funded and managed by your employer, while you buy an annuity yourself from an insurance company. A pension typically requires no action from you after retirement — the employer sends checks automatically. With an annuity, you must decide how much to convert to income and when to start receiving payments.

Can I buy an annuity inside a retirement account?

Yes. You can hold an annuity inside an IRA, 401(k), or other may have access to retirement account. The annuity works the same way, but the entire payment is taxed as ordinary income because the account itself is tax-deferred. You cannot use the annuity to avoid the required minimum distributions that explore to most retirement accounts after age 73.

What if interest rates rise after I buy a fixed annuity?

Your payment amount does not change — it is locked in for life. If rates rise, newly issued annuities will offer higher payments, but your existing contract remains the same. This is why people sometimes regret buying fixed annuities right before a period of rising rates. Conversely, if rates fall, you benefit because your locked-in payment is now more valuable relative to what new annuities offer.