What Is an Annuity?
An annuity is a financial contract between you and an insurance company. You make a lump-sum payment or series of payments, and in return, the insurer provides you with regular income payments, either immediately or at some point in the future. Annuities are primarily used as a retirement income tool, designed to help ensure you do not outlive your savings.
At its core, an annuity converts a sum of money into a predictable income stream. This can last for a fixed number of years or for the rest of your life, depending on the contract terms. Because annuities are issued by insurance companies, they function differently from traditional investments like stocks, bonds, or mutual funds.
"An annuity is the only financial product that can guarantee you will not outlive your money, which is the fundamental risk of retirement."
How Annuities Work
Annuities operate in two distinct phases:
Accumulation Phase
During the accumulation phase, you contribute money to the annuity. This can be a single lump-sum payment or a series of payments over time. Your money grows tax-deferred during this phase, meaning you do not pay taxes on investment gains, interest, or dividends until you begin withdrawing funds. This tax-deferred growth is one of the key advantages of annuities.
Distribution Phase (Annuitization)
During the distribution phase, the insurance company begins making regular payments to you. The amount you receive depends on the total value of your annuity, the payout option you select, your age, and current interest rates. You can choose to receive payments for a specific number of years, for the rest of your life, or for the joint lives of you and a spouse.
Types of Annuities
Fixed Annuities
A fixed annuity guarantees a specific interest rate on your contributions for a set period. The insurance company assumes all investment risk, providing you with predictable, stable growth. Fixed annuities are the simplest and most conservative type, functioning similarly to a certificate of deposit (CD) but with tax-deferred growth. They are ideal for risk-averse investors who prioritize safety and guaranteed returns.
Variable Annuities
A variable annuity allows you to invest your contributions in a selection of sub-accounts, which function like mutual funds. Your returns depend on the performance of these underlying investments, meaning your account value can increase or decrease based on market conditions. Variable annuities offer greater growth potential than fixed annuities but also carry more risk and typically have higher fees.
Indexed Annuities
An indexed annuity (also called a fixed-indexed annuity) offers returns linked to the performance of a market index, such as the S&P 500. They typically guarantee a minimum return (often 0-2%) while offering participation in a portion of index gains, up to a cap. Indexed annuities sit between fixed and variable annuities in terms of risk and return potential. The insurance company uses complex formulas to calculate your credited interest, including caps, spreads, and participation rates.
Immediate Annuities
An immediate annuity begins paying income within one year of purchase, typically within 30 days. You make a lump-sum payment, and the insurance company starts sending you regular checks. Immediate annuities are used by retirees who want to convert savings into guaranteed income right away. Once purchased, the contract is usually irrevocable, meaning you cannot get your lump sum back.
Deferred Annuities
A deferred annuity delays income payments to a future date, allowing your money to grow during the accumulation phase. This can be years or even decades before you begin receiving payments. Deferred annuities are suited for individuals who are still working and want to build up retirement savings with tax-deferred growth before converting to an income stream later.
Annuity Fees and Charges
Annuities are often criticized for their fees, which can significantly reduce returns. Understanding these costs is essential before purchasing:
- Surrender Charges: Fees charged if you withdraw money during the surrender period, which typically lasts 5-10 years. These charges often start at 7-10% of the withdrawal amount and decrease each year until the surrender period ends.
- Mortality and Expense (M&E) Charges: An annual fee (typically 1.0-1.5%) charged by the insurance company to cover insurance guarantees, profit, and administrative costs. This is specific to variable annuities.
- Administrative Fees: Annual charges for record-keeping and account management, often $25-$50 per year or built into the M&E charge.
- Investment Management Fees: Sub-account expenses in variable annuities, similar to mutual fund expense ratios. These typically range from 0.5% to 2.0% annually.
- Rider Charges: Optional features (such as guaranteed minimum income, death benefits, or long-term care riders) add additional annual fees, often 0.25% to 1.0% each.
When you add up all the fees in a variable annuity, total annual costs can reach 2-4% of your account value. Compare this with a low-cost index fund at 0.03-0.10% to understand why fees are such a critical consideration.
Tax Treatment of Annuities
Annuities receive special tax treatment that distinguishes them from other investment accounts:
- Tax-Deferred Growth: Investment earnings grow without being taxed each year. You only pay taxes when you withdraw money, which can allow for faster compounding during the accumulation phase.
- Ordinary Income Tax on Withdrawals: When you take distributions, the earnings portion is taxed as ordinary income (not at the lower capital gains rate). Contributions made with after-tax dollars are not taxed again upon withdrawal.
- 10% Early Withdrawal Penalty: Withdrawals taken before age 59 and a half are generally subject to a 10% federal tax penalty on the earnings portion, in addition to ordinary income tax.
- No Contribution Limits: Unlike IRAs and 401(k)s, annuities have no annual contribution limits. This makes them attractive for high earners who have already maxed out other tax-advantaged accounts.
- Death Benefits: If the annuity owner dies during the accumulation phase, beneficiaries receive the account value but must pay income tax on the earnings. Unlike many other assets, annuities do not receive a stepped-up cost basis at death.
Advantages of Annuities
- Guaranteed Lifetime Income: The only financial product that can guarantee income for as long as you live, eliminating the risk of outliving your savings
- Tax-Deferred Growth: No annual taxes on investment gains, allowing your money to compound more efficiently
- No Contribution Limits: Invest as much as you want, unlike capped retirement accounts
- Death Benefit Protection: Many annuities guarantee that beneficiaries will receive at least the amount you invested, even if the market value is lower
- Predictable Income: Fixed and immediate annuities provide stable, predictable payments that simplify retirement budgeting
- Creditor Protection: In many states, annuity assets receive some protection from creditors and lawsuits
Disadvantages of Annuities
- High Fees: Variable annuities in particular carry multiple layers of fees that can substantially reduce long-term returns
- Illiquidity: Surrender charges lock up your money for years, and early withdrawals may trigger both penalties and taxes
- Complexity: Annuity contracts can be dozens of pages long with complex formulas for calculating returns, especially indexed annuities
- Ordinary Income Tax: Gains are taxed at ordinary income rates rather than the more favorable long-term capital gains rates
- No Stepped-Up Basis: Unlike stocks or real estate, annuity gains do not receive a tax-free step-up in cost basis when inherited
- Insurance Company Risk: Your annuity is only as secure as the insurance company behind it. While rare, insurance companies can fail
- Inflation Risk: Fixed annuity payments may lose purchasing power over time unless the contract includes an inflation rider
Who Should Consider Annuities?
Annuities are not appropriate for every investor. They may be a good fit if you:
- Have already maximized contributions to your 401(k), IRA, and other tax-advantaged retirement accounts
- Are concerned about outliving your retirement savings and want guaranteed lifetime income
- Are within 10-15 years of retirement or already retired
- Have a low risk tolerance and want predictable, stable returns (fixed annuities)
- Want to supplement Social Security and pension income with an additional guaranteed income stream
- Are a high earner looking for additional tax-deferred savings beyond IRA and 401(k) limits
Annuities are generally not recommended for young investors with long time horizons, investors who may need access to their money within the surrender period, or those who have not yet maximized lower-cost tax-advantaged accounts.
Annuities vs Other Retirement Options
| Feature | Annuity | 401(k) / IRA | Taxable Brokerage |
|---|---|---|---|
| Tax-Deferred Growth | Yes | Yes | No |
| Contribution Limits | None | $23,000 / $7,000 | None |
| Guaranteed Income | Yes (with annuitization) | No | No |
| Fees | Higher (1-4% for variable) | Low (0.03-0.50%) | Low (0.03-0.50%) |
| Liquidity | Limited (surrender charges) | Limited (penalties before 59.5) | Full liquidity |
| Tax on Withdrawals | Ordinary income | Ordinary income (Traditional) / Tax-free (Roth) | Capital gains rates |
| Employer Match | No | Often yes (401k) | No |
Surrender Periods: What You Need to Know
The surrender period is the time frame during which you will face charges for withdrawing money from your annuity. Surrender periods typically last 5-10 years, and the charges decrease over time. For example, a 7-year surrender schedule might charge 7% in year one, 6% in year two, and so on until reaching 0% after year seven.
Most annuities allow penalty-free withdrawals of up to 10% of the account value per year, even during the surrender period. Understanding the surrender schedule before purchasing is crucial, as unexpected expenses or financial emergencies could force costly early withdrawals.
Choosing an Annuity Provider
When selecting an annuity provider, consider these factors:
- Financial Strength Ratings: Check ratings from agencies like A.M. Best, Moody's, and Standard & Poor's. Choose insurers rated A or higher to ensure they can meet their long-term obligations.
- Fee Transparency: Request a complete breakdown of all fees, including surrender charges, M&E charges, sub-account fees, and rider costs. Compare total costs across multiple providers.
- Product Options: Evaluate the range of annuity products offered and whether they align with your needs and risk tolerance.
- Customer Service: Research the company's reputation for customer service, claims processing, and responsiveness.
- State Guaranty Association Coverage: Each state has a guaranty association that provides protection if an insurer becomes insolvent, typically up to $250,000. Verify your state's coverage limits.
