Annuities may help you meet some of your medium- and long-term financial goals, including retirement planning and funding a child’s college education. This guide explains how annuities work, explores the different types available, and discusses how to assess whether an annuity may suit your circumstances. It also covers the tax treatment of annuities and what to consider when comparing insurance companies and annuity contracts.
Table of Contents
- How Annuities Work
- How Annuities Best Serve Investors
- Types of Annuities
- Choosing a Payout Option
- How Payouts Are Taxed
- How to Shop for an Annuity
- Costs, Penalties, and Extras
- Risks to Retirees of Using an Immediate Annuity
How Annuities Work
Traditional life insurance helps protect against the financial consequences of dying too soon. An annuity, in contrast, can help protect against the risk of outliving your savings.
When you purchase an annuity, usually from an insurance company, you provide funds that the insurer manages according to the contract. In return, you may receive a series of periodic payments for a specified period or for the rest of your life.
If you select lifetime payments, the annuity can provide a continuing income stream for as long as you live, subject to the terms of the contract and the insurer’s ability to meet its obligations. If you die earlier than expected, the total payments you receive may be less than the amount you paid. If you live longer than expected, you may receive more than your original investment and its associated earnings.
By comparison, money held in traditional investments can be depleted if withdrawals continue for longer than anticipated.
Earnings within many annuity contracts receive tax-deferred treatment. Generally, you do not pay tax on those earnings until they are distributed, although the exact treatment depends on the type of annuity and how it is held.
How Annuities Best Serve Investors
Assess the costs of an annuity relative to the alternatives. Purchasing life insurance separately and investing in tax-deferred accounts may be more cost-effective in some circumstances.
The two primary reasons to consider an annuity as an investment vehicle are:
- You want to save money for a long-term financial goal.
- You want a guaranteed stream of income for a specified period or, depending on the contract, for life.
Annuities may be particularly useful for retirement planning and, in certain circumstances, education funding.
Access to Your Money and Early-Withdrawal Penalties
One disadvantage of annuities is that accessing your money during the accumulation period may result in taxes, tax penalties, surrender charges, or other fees.
Under U.S. federal tax rules, certain taxable withdrawals from annuities before age 59½ may be subject to an additional 10% tax unless an exception applies. Insurance companies may also impose surrender charges when money is withdrawn during the contract’s surrender period. The length and amount of these charges vary by contract.
These restrictions mean an annuity may be unsuitable for money you expect to need in the near future. Before investing, consider whether you can leave the funds invested for the required period and whether the contract’s withdrawal rules fit your plans.
Investment growth may affect how you view the cost of an early withdrawal. However, the additional tax generally applies only to the taxable portion of a distribution, and the overall consequences depend on your contract and tax circumstances.
Annuities for Education Funding
Annuities have sometimes been considered for education savings, including arrangements held in a child’s name under applicable custodial rules. In such cases, the tax treatment of earnings and withdrawals depends on the account structure and the law that applies.
A significant consideration is that money held for a child may become available for the child’s use according to the applicable custodial arrangement and legal requirements. It may not be restricted exclusively to education expenses.
Before using an annuity for education savings, compare it with alternatives designed specifically for education funding and consider the fees, tax treatment, investment flexibility, and control over the funds.
Types of Annuities
Annuity products differ in how money is contributed, when payments begin, how withdrawals are made, and how the funds are invested. The following are common types of annuities.
Single-Premium Annuities
A single-premium annuity is funded with one payment. For example, an investor might use a lump sum received from a retirement plan to purchase the contract.
The minimum investment depends on the insurer and product. The original source cites amounts of $5,000 or $10,000, but actual minimums vary by contract and should be confirmed with the provider.
Flexible-Premium Annuities
A flexible-premium annuity is funded through a series of contributions rather than one large initial payment. Depending on the contract, the first contribution may be relatively small, with additional payments made over time.
Immediate Annuities
An immediate annuity begins making payments shortly after it is funded, according to the contract’s terms. It is usually purchased with a single premium and may appeal to retirees who want to convert accumulated savings into a stream of income.
Deferred Annuities
With a deferred annuity, payments begin at a later date. Depending on the contract, the owner may eventually choose a lump-sum distribution or regular annuity payments over a specified period or for life.
Deferred annuities may be used for long-term retirement planning by both retirees and non-retirees. They can be funded through a single premium or a series of contributions.
Fixed Annuities
With a fixed annuity, the insurer generally credits interest according to the contract’s terms. The contract may guarantee a minimum interest rate for a specified period, and rates on some products may be adjusted at the end of a guarantee period.
A fixed annuity may be suitable for investors who prioritize contractual guarantees and are comfortable with the product’s liquidity restrictions. However, guarantees depend on the financial strength and claims-paying ability of the issuing insurer.
Fixed annuities are sometimes compared with certificates of deposit or money-market products, but they are not identical. Their liquidity, tax treatment, guarantees, and regulatory protections differ. The source’s reference to guaranteed interest rates of 3% to 5% should be treated as historical rather than as a current market promise.
Variable Annuities
A variable annuity allows the owner to allocate money among investment options offered under the contract, which may include stock, bond, and cash-equivalent portfolios.
Unlike a traditional fixed annuity, the investment value and returns of a variable annuity generally fluctuate with the selected investments. The principal and investment return are not automatically guaranteed, although some contracts offer optional guarantees subject to additional costs and conditions.
Variable annuities generally provide tax-deferred growth, but their fees and investment risks should be carefully evaluated.
Some variable annuity contracts allow you to change investment allocations periodically, either without charge or for a fee.
Variable annuities may suit investors who can tolerate market fluctuations and have a long investment horizon. However, they can cost more than comparable investments held outside an insurance contract.
For U.S. federal tax purposes, the taxable portion of a distribution from a nonqualified annuity is generally taxed as ordinary income rather than receiving preferential capital-gains treatment simply because the underlying investments include stocks.
Combining Fixed and Variable Features
Some annuity products combine fixed and investment-linked features. Before purchasing an annuity, consider whether you have already taken advantage of other retirement savings options, such as an IRA or a 401(k) plan, when eligible.
These alternatives may have different contribution limits, tax advantages, investment choices, and costs. The appropriate order of funding depends on your circumstances, including employer benefits, tax position, and retirement goals.
Holding an annuity inside a tax-advantaged retirement account does not necessarily provide an additional tax-deferral benefit beyond the account’s existing tax treatment. Compare the costs and benefits before choosing an annuity for an IRA or another retirement plan.
Choosing a Payout Option
When it is time to receive money from a deferred annuity, you may have several payout choices. Many owners choose regular payments, while some contracts also allow a lump-sum withdrawal.
Review the contract carefully before choosing a payout option. Some elections are irrevocable or difficult to change once payments begin.
The amount of each payment generally depends on:
- The value of the annuity contract.
- Any minimum or required payments under the contract.
- Your life expectancy or the selected payout period.
- Whether payments continue to a beneficiary after your death.
Common payout options include the following.
Fixed Amount
This option provides a fixed payment amount that continues until the annuity funds are exhausted.
The main risk is that you may live longer than the money lasts. If the annuity is your only source of retirement income, this option may not provide sufficient protection against longevity risk. If you die before the account is exhausted, any remaining balance may pass to a beneficiary, depending on the contract.
Fixed Period
This option pays an amount over a period you select, such as ten years. It may be useful if you need income until another retirement benefit begins or for a particular financial objective.
If you die before the selected period ends, the remaining payments may continue to a beneficiary according to the contract terms.
Lifetime or Straight Life
A straight-life annuity pays income for as long as you live. Under this option, payments generally stop when you die, and no further payments are made to survivors.
Because the insurer does not have to guarantee payments to a beneficiary after your death, this option may provide a higher monthly payment than options that include survivor benefits. It may suit someone who wants to maximize lifetime income and does not need the annuity to provide an inheritance.
The principal risk is dying earlier than expected and receiving less in total payments than the amount invested.
Life With Period Certain
This option provides payments for life while guaranteeing payments for a minimum period. If you die before that period ends, your beneficiary generally receives payments for the remainder of the guaranteed period.
A longer guarantee period generally results in a lower monthly payment than a comparable option with a shorter guarantee period.
Installment-Refund
An installment-refund option pays income for life and provides for a beneficiary to receive payments if you die before the contract has returned the specified amount of your original investment.
Monthly payments are generally lower than those available under a straight-life annuity because of the additional protection for beneficiaries.
Joint and Survivor
A joint-and-survivor annuity pays income over the joint lives of two annuitants, commonly a retired employee and a spouse. After the first annuitant dies, the surviving person continues to receive payments at the same or a reduced amount, depending on the option selected.
The amount paid depends on factors such as the ages of the annuitants and whether the survivor will receive 100% of the original payment or a smaller percentage.
Compare the available survivor-benefit options carefully, particularly if a spouse or another beneficiary will rely on the income.
How Payouts Are Taxed
The tax treatment of annuity payments depends in part on whether the annuity is held within a qualified retirement arrangement or is a nonqualified annuity purchased outside such an arrangement. The rules below describe general U.S. federal tax principles.
Qualified Annuity
A qualified annuity is held as part of a tax-qualified retirement arrangement, such as an IRA, 401(k), SEP, or another eligible retirement plan. The applicable plan rules determine the tax treatment of contributions, earnings, and distributions.
In general, the potential tax benefits include:
- Eligible after-tax contributions or other amounts representing basis may not be taxed again when distributed, subject to the applicable plan rules.
- Investment earnings generally receive tax-deferred treatment until distribution.
Distributions from qualified retirement arrangements are often taxable as ordinary income, except to the extent they represent basis or otherwise qualify for different treatment under the relevant rules.
Early Distributions and Required Minimum Distributions
Certain taxable distributions taken before age 59½ may be subject to an additional 10% federal tax unless an exception applies. Exceptions depend on the type of account, the circumstances, and the applicable law.
Required minimum distribution (RMD) rules may also apply to qualified retirement accounts. The applicable starting age depends on birth year and account type, and exceptions may apply to certain Roth accounts and eligible employees who continue working.
The original source discusses the changes made by the SECURE Act 2.0 of 2022 and lists specific RMD ages for different birth years. Because those rules are date-sensitive, confirm the applicable RMD age and distribution requirements under current IRS guidance before relying on the historical figures.
Nonqualified Annuity
A nonqualified annuity is generally purchased with after-tax money outside a tax-qualified retirement plan. Earnings within the contract may grow tax-deferred, but distributions can be taxable to the extent they represent earnings.
Withdrawals from a nonqualified annuity before age 59½ may be subject to an additional 10% federal tax on the taxable portion unless an exception applies.
Nonqualified annuities are generally not subject to the same required minimum distribution rules that apply to traditional tax-deferred retirement accounts during the owner’s lifetime. However, different distribution rules may apply after the owner’s death.
Tax on Beneficiaries or Heirs
If annuity payments continue after your death, your beneficiary or heirs may have tax obligations. The treatment depends on the contract, the type of annuity, how it is held, and the applicable federal and state laws.
Income tax: Payments received by beneficiaries are generally subject to the relevant annuity income-tax rules. The taxable portion and timing depend on the contract and the beneficiary’s circumstances.
Additional tax on early distributions: The additional 10% federal tax that may apply to certain early distributions generally does not apply to distributions made after the annuity owner’s death, although regular income tax may still apply.
Estate tax: Annuity benefits may be included in the owner’s estate for federal estate-tax purposes, depending on the ownership arrangement and applicable rules. Spousal transfers and charitable arrangements may receive different treatment, subject to the relevant requirements.
When evaluating an annuity, also consider the insurer’s financial strength and the investment options available. Past performance does not guarantee future results, and changes in investment management may affect future performance.
How to Shop for an Annuity
Annuities are typically issued by insurance companies and may be purchased through insurance agents, banks, or securities professionals, depending on the product and applicable licensing rules.
Fees, features, guarantees, and contract terms can vary considerably. Compare both the cost and the quality of the product before making a decision.
First, Check Out the Insurer
Before evaluating an annuity contract, assess the financial strength of the insurance company issuing it.
Annuity guarantees generally depend on the issuing insurer’s claims-paying ability. Annuities are not federally guaranteed in the same way as certain bank deposits, and any applicable state guaranty-association protection is subject to specific limits and eligibility rules.
You can review insurer financial-strength information from rating organizations such as:
Ratings are useful reference points, but they are opinions about financial strength rather than guarantees that an insurer will meet every future obligation.
Next, Compare Contracts
The factors to compare depend on the type of annuity you are considering.
Immediate annuities: Compare the available payout options. For each $1,000 invested, how much monthly income will the contract provide? Also consider whether payments continue to a beneficiary, whether payments increase over time, and what restrictions apply.
Deferred annuities: Compare the interest rate, the length of any guarantee period, renewal terms, withdrawal restrictions, and the contract’s history of credited rates where relevant. Do not base your decision on a high initial rate alone.
Variable annuities: Review the available investment options, their objectives, their fees, and their historical performance. Past performance is not a guarantee of future returns.
If a particular investment option has a strong performance history, check whether its management team and investment approach have remained consistent. This information can help with your assessment, but it cannot eliminate investment risk.
Costs, Penalties, and Extras
Before purchasing an annuity, review the following costs and contract features.
Surrender Penalties
Find out what surrender charges apply if you withdraw money or terminate the contract early. Some contracts impose higher charges in the first few years and reduce them over time.
The original source describes a schedule beginning at 7% in the first year, 6% in the second year, and declining until no charges apply after the seventh year. This is an illustrative historical schedule, not a universal standard. Actual surrender periods, percentages, and exceptions vary by contract.
Check when the surrender-charge period begins and how additional contributions affect it. Do not assume that every contract uses the same start date or withdrawal schedule.
Fees and Costs
Ask for a complete explanation of all charges. With variable annuities, review the prospectus and contract disclosures carefully.
Possible fees and expenses include:
- Mortality and expense risk charges: Fees associated with certain insurance guarantees and risks assumed by the insurer.
- Administrative or maintenance fees: Charges for maintaining the contract.
- Investment management fees: Expenses charged for managing the underlying investment portfolios.
- Optional benefit fees: Additional costs for riders or guarantees selected under the contract.
- Surrender charges: Fees that may apply to certain withdrawals or early termination.
The source gives historical examples of mortality charges of 1% to 1.35%, annual maintenance fees of $20 to $30, and investment advisory fees of 0.3% to 1%. Actual costs may differ substantially by product, insurer, and contract date. Review current disclosures rather than relying on these figures.
Extras
Some contracts include optional features that may be useful in particular circumstances.
Bail-out provisions: Certain contracts may permit an owner to withdraw funds or terminate the contract without a surrender charge if specified conditions are met, such as a change in the credited interest rate. Read the exact conditions and restrictions.
Persistency bonuses: Some contracts offer bonuses or enhanced benefits for keeping the annuity for a specified period. Review how the bonus is calculated and whether other charges, restrictions, or conditions offset its value.
Because annuities can involve complex guarantees, tax rules, and long-term costs, consider obtaining professional advice before choosing a contract.
Risks to Retirees of Using an Immediate Annuity
An immediate annuity may appear attractive to retirees who receive a lump-sum distribution or have accumulated retirement savings. A single premium can be converted into regular payments—monthly, quarterly, or annually—that may continue for life under the selected contract.
However, immediate annuities also involve risks that should be considered before committing a substantial amount of retirement savings.
Inflation Risk
When you choose a lifetime annuity with level payments, the purchasing power of those payments may decline as prices rise. A payment that covers your expenses today may buy less in the future.
Longevity and Beneficiary Risk
The value you receive from a lifetime annuity depends partly on how long you live and the payout option you select.
For example, if you purchase a $150,000 annuity and die after receiving only $60,000 in payments, the insurer may retain the remaining value under a straight-life arrangement. A beneficiary may receive no further payments under that option.
Other options, such as a period-certain guarantee, a joint-and-survivor benefit, or a refund feature, may provide continued payments or other benefits to a beneficiary. These features generally affect the amount of the initial periodic payment.
Interest-Rate Risk
The payment rate offered when you purchase a fixed immediate annuity may be less attractive than rates available later. Once you commit to a contract, you may have limited ability to change the terms or access the funds without cost.
Options for Managing These Risks
You may be able to address some of these concerns by choosing a different payout structure.
- Period-certain or term-certain option: Provides payments for a guaranteed minimum period, even if you die during that period.
- Joint-and-survivor option: Continues payments to a spouse or another joint annuitant after the first person’s death, according to the contract.
- Refund feature: May provide for some or all of the specified remaining amount to be paid to a beneficiary.
- Inflation-adjusted payments: Some contracts offer payment increases or cost-of-living features, often in exchange for a lower initial payment or additional cost.
- Variable immediate annuity: Links payments to investment performance, which may create the potential for different returns but also introduces market risk.
The original source describes an example of a contract that increases payments by $10 every three years for the first 15 years, followed by annual cost-of-living adjustments capped at 3%. This is a historical illustration, not a description of a universally available current product.
Variable immediate annuities convert an initial premium into an income stream whose payments may depend on the performance of selected investments. They can offer market participation but do not eliminate investment risk.
Is an Immediate Annuity Right for You?
Age alone should not determine whether an immediate annuity is appropriate. Your income needs, health and longevity considerations, other assets, liquidity requirements, inflation exposure, and plans for beneficiaries all matter.
If your goal is to maintain a comfortable retirement income, you may also compare an annuity with a diversified investment portfolio and a planned withdrawal strategy. An annuity can provide contractual income, while a portfolio may offer greater liquidity and flexibility but does not provide the same lifetime-income guarantees.
Consider how much of your retirement savings you can commit without compromising your ability to cover emergencies, unexpected expenses, and future changes in your circumstances.
