What is an annuity?

An annuity is a long-term financial contract that can provide you with a stream of payments later in return for an investment now. Annuities can help with retirement income, estate planning or tax deferral.

There are three main arguments for buying an annuity:

  • Retirement income: You might need more than Social Security to live on in retirement. An annuity can provide steady income so you don’t outlive your savings.

  • Estate planning: Annuities can provide income to your beneficiaries if you die, and in some cases, without going through probate.

  • Tax deferral: You don’t pay taxes on investment gains in an annuity until you withdraw the money.

Confused about how annuities can help you?

How do annuities work?

Annuities can be complex, but here’s an overview of some characteristics to know.

The annuity life cycle

Typically, there are two stages to annuity investments.

  1. Accumulation. You contribute a lump sum of money or make a series of payments to the annuity provider. Whether and how that money is invested while you wait to begin taking payments depends on the type of annuity you buy. This phase could be very short or last decades.

  2. Annuitization. The payout phase starts when you begin getting checks. You might opt for a lump-sum payment, though often people choose to receive a regular monthly payment.

There are several kinds of annuities. Here are some common ones.

  • Immediate annuity: An annuity that begins paying out right away.

  • Deferred annuity: An annuity that begins paying out later. You may get bigger payouts this way because your money has more time to accumulate investment gains.

  • Fixed annuity: You pay a premium that’s invested at a fixed rate. The investment grows based on a guaranteed rate of return.

  • Variable annuity: An annuity that allows you to choose where to invest your premium, such as in mutual funds and bond funds. Depending on the provider, the annuity might provide a guaranteed minimum return and/or cap the maximum amount of growth. That means your investment returns or payments may never fall below a certain level (or go above a certain level). You could have higher earnings, but also more risk.

  • Equity-indexed annuity: Here, the growth tracks to some degree a stock index such as the S&P 500, and you get guaranteed minimum payments (they also may be capped). You could have higher earnings, but also more risk.

  • Riders: You can customize an annuity by purchasing riders. Riders are optional, add-on features. They vary by issuer. Some examples include living benefits, where you get guaranteed increases in your payouts at a certain time, and death benefits, where you have the annuity pay your funeral costs or pay a beneficiary.

Annuity Taxes

Annuities are tax-deferred instruments, which means that typically, you pay tax on the income and/or earnings in the account only when you take money out.  Generally, if you buy an annuity with pre-tax dollars, like through your 401(k) or IRA, the payments you later receive from the annuity are taxed at regular income tax rates (not capital gains rates, which are usually lower). Annuities funded with pre-tax money are called qualified annuities.

If you buy an annuity through a Roth IRA or Roth 401(k), the income may be completely tax-free.

If you buy an annuity with money you already paid taxes on, then generally only the part of the account that is gains or earnings is taxed when you withdraw money from your annuity.