What is an Annuity?

An annuity is a contract with an insurance company: you hand over a sum of money, and in exchange the company pays you income, either starting immediately or at some point in the future. The defining feature is that the payments can be guaranteed for life, which makes an annuity one of the few ways to convert savings into income you cannot outlive.

That guarantee is what distinguishes an annuity from an investment account, though not every contract is bought for it. The rest of the product varies in how the money is held before payments begin and what the insurer charges for the arrangement.

How an Annuity Works

Most annuities have two phases. During accumulation you pay in, either as a lump sum or over time, and the balance grows tax-deferred. During annuitization the contract converts to a stream of payments, calculated from your age, the amount, prevailing interest rates, and the payout option you choose.

You do not have to annuitize. Many contracts are held for the tax-deferred growth and surrendered or passed to heirs instead, though that leaves the main advantage unused.

Payout options are where the tradeoff gets set. A single life payout gives the highest monthly amount and stops at your death. Joint and survivor continues to a spouse, at anything from a reduced percentage up to 100% of the original payment, with a lower starting amount than a single life payout. Period certain guarantees payments for a set number of years even if you die early, at a lower monthly figure.

Types of Annuities

Immediate and deferred income annuities are the simplest and generally the cheapest. Variable and fixed indexed contracts have the most moving parts, though their costs surface differently: a variable contract charges explicit annual fees, while a fixed indexed contract’s cost is mostly embedded in the caps and participation rates that limit how much of an index gain reaches you.

Annuity Fees and Common Criticisms

Annuities attract more criticism than most financial products, and the costs are the reason.

Fees stack. Variable annuities commonly carry mortality and expense charges, administrative fees, and subaccount expenses that together can run well above 2% a year. Surrender charges lock the money up, often starting near 7% and declining over six to eight years. Commissions vary widely by contract type, which is worth asking about directly before buying.

Complexity is its own cost. Fixed indexed contracts in particular involve caps, participation rates, and spreads that determine how much of an index gain you actually receive, and those terms can often be changed by the insurer.

And the guarantee is only as good as the insurer. Annuities are not federally insured. State guaranty associations provide backstops with limits that vary, so the issuer’s financial strength rating matters.

When an Annuity Makes Sense

The clearest case is a specific one: you are retired or near it, your guaranteed income from Social Security and any pension does not cover your essential expenses, and you want that gap filled for life regardless of what markets do.

Used that way, a simple immediate annuity covering the shortfall between guaranteed income and baseline spending can let you hold the rest of the portfolio more aggressively, because the money you truly need is no longer exposed to sequence risk. You can test an income floor against portfolio withdrawals in ProjectionLab to see whether it changes your outcome.

The case is weaker where the goal is tax deferral on its own, since a 401(k) or IRA generally provides it at lower cost, or equity exposure through a variable contract, where an index fund in a taxable account is usually cheaper.

Frequently Asked Questions

How are annuity payments taxed? In a qualified annuity bought with pre-tax money, the entire payment is taxed as ordinary income. In a non-qualified annuity bought with after-tax money, each annuitized payment is part return of principal (tax-free) and part earnings (ordinary income), split by an exclusion ratio.

That split applies once payments have started. Take a one-off withdrawal from a non-qualified contract still in accumulation and the earnings come out first and are fully taxable, with a 10% additional tax on top if you are under 59.5, unless an exception applies. Either way the earnings are ordinary income, not capital gains.

Can I get my money back if I change my mind? Usually, minus a surrender charge, and most contracts include a free-look period of 10 to 30 days for a full refund. Once you annuitize an immediate annuity, the decision is generally irreversible.

What happens to an annuity when I die? With a single life payout, payments stop. With joint and survivor or period certain, they continue under the terms you selected. Deferred annuities still in accumulation pass to your named beneficiary, and the gains are taxable to them as ordinary income.

Are annuities a good investment? Every annuity is an insurance contract, and variable annuities are securities as well, so the answer depends on what you are buying it for. As insurance against outliving your money, a simple income annuity can be reasonable. As a growth vehicle, the costs generally make it an expensive route to what cheaper accounts already provide.