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

You give an insurance company a sum of money — either all at once or over time — and in return, the company promises to pay you a set amount at regular intervals. Those intervals might be monthly, quarterly, or annually, and they might last for a fixed number of years or for the rest of your life. The insurance company holds your money, invests it, and uses the returns to fund your payments.

The appeal is predictability. Once you buy an annuity, you know exactly how much will arrive and when. You do not have to decide how to invest the money, worry about market swings, or wonder if you will run out of cash in retirement. The insurance company takes on that risk instead.

Key Takeaways

• An annuity converts a lump sum into a stream of regular payments, either for a set period or for life.
• You purchase an annuity from an insurance company, which then invests your money and sends you payments on a schedule you choose.
• Fixed annuities pay the same amount every period; variable annuities pay amounts that change based on investment performance.
• Once you buy an annuity, you usually cannot get your money back in a lump sum, so annuities work best for money you do not expect to need urgently.

How you buy an annuity

You work with an insurance agent or financial advisor who sells annuities. You tell them how much money you have to invest and what kind of payment schedule you want — for example, monthly payments starting at age 65, or payments that last exactly 20 years. The insurance company quotes you a monthly or annual payment amount based on your age, the amount you invest, current interest rates, and how long the payments will last.

Once you agree to the terms and sign the contract, you send the money to the insurance company. That money is now locked into the annuity. The insurance company begins making payments on the date you specified in the contract.

Fixed annuities versus variable annuities

A fixed annuity pays you the same amount every month or year for the life of the contract. The insurance company guarantees that payment, no matter what happens in the markets. If you buy a fixed annuity that pays $1,500 a month, you will receive $1,500 a month — that does not change. This makes budgeting straightforward, but it also means your payments do not grow if inflation rises.

A variable annuity ties your payments to the performance of investments you choose — usually mutual funds or similar options offered by the insurance company. If those investments do well, your payments go up. If they perform poorly, your payments go down. You have more upside potential than with a fixed annuity, but you also carry the investment risk. The insurance company does not promise a minimum payment amount.

when ready annuities and deferred annuities

An when ready annuity starts paying you within a few months of purchase. You hand over a lump sum, and the insurance company begins sending payments right away. This works well if you have just retired and need income to start flowing when ready.

A deferred annuity does not start paying you until a future date you choose — perhaps 10 or 20 years from now. During the waiting period, your money grows inside the annuity. When the payout date arrives, the insurance company begins sending payments. Deferred annuities appeal to people who are still working and want to lock in a future income stream.

What happens to your money after you buy

Once you purchase an annuity, the money belongs to the insurance company, not to you. You cannot withdraw it as a lump sum or change your mind and get it back. Some annuities allow you to withdraw a small percentage each year without penalty, but most do not. If you try to withdraw more than the contract allows, you will pay a surrender charge — a fee that can be substantial, especially in the early years.

This is why annuities suit money you do not expect to need. If you might need the cash for an emergency or a major purchase, an annuity is not the right tool. But if you have retirement savings you want to convert into may provide income, an annuity removes the guesswork.

Who typically buys annuities

People in or near retirement often buy annuities to create a predictable income stream. Someone who receives a lump-sum pension payout, an inheritance, or a settlement might use an annuity to turn that money into monthly checks. Self-employed people or those without a traditional pension sometimes use annuities to replicate the steady paycheck they would have received from an employer.

Annuities are less common for younger workers or people who might need access to their savings. They are also less common for people who are comfortable managing their own investments and do not mind market risk in exchange for the possibility of higher returns.

Costs and fees you should know about

Annuities come with costs. Insurance companies charge commissions to the agents who sell them — typically 5 to 10 percent of the amount you invest, though you usually do not pay this directly; it comes out of your investment. Variable annuities charge annual management fees, often 1 to 3 percent per year. Some annuities include riders — add-on features like a death benefit or long-term care coverage — that cost extra.

If you withdraw money before the contract term ends, you pay a surrender charge. These fees decline over time; a 7 percent surrender charge in year one might drop to 1 percent by year seven. Always ask the insurance agent to explain all fees in writing before you buy.

Frequently Asked Questions

Can I change my mind after I buy an annuity?

Most annuities have a surrender period, usually 5 to 10 years, during which you can withdraw money but will pay a penalty. After the surrender period ends, you can withdraw without penalty, though you still cannot get your money back as a lump sum unless the contract allows it. Read the contract carefully before signing.

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 level of protection varies by state but typically covers up to $250,000 per person per company. Ask your agent which state's guaranty fund covers your annuity.

Is an annuity the same as a pension?

No. A pension is a benefit your employer provides and funds. An annuity is a product you buy with your own money. However, an annuity can work similarly to a pension by turning a lump sum into regular payments for life.

Do I pay taxes on annuity payments?

Yes. If you buy an annuity with pre-tax money (like from a traditional IRA), your payments are fully taxable. If you buy with after-tax money, only the earnings portion of each payment is taxed. The insurance company will send you a tax form each year showing what portion is taxable.

What if I die before the annuity payments end?

That depends on the contract. Some annuities stop paying when you die; others continue paying your beneficiary for the remainder of the term. Some include a death benefit that pays your beneficiary the remaining balance. Ask the insurance agent which option applies to the annuity you are considering.