How Do Annuities Work?
An annuity is a long-term contract between you and an insurance company. You pay either a lump sum or a series of payments. The insurer invests those funds, and in return, you receive regular and guaranteed payments for a specified time or the rest of your life. Each type of annuity works differently.
- Written by Rachel Christian
Financial Writer and Certified Educator in Personal Finance
Rachel Christian is a writer and researcher for RetireGuide. She covers annuities, Medicare, life insurance and other important retirement topics. Rachel is a member of the Association for Financial Counseling & Planning Education.Read More
- Edited ByLee Williams
Senior Financial Editor
Lee Williams is a professional writer, editor and content strategist with 10 years of professional experience working for global and nationally recognized brands. He has contributed to Forbes, The Huffington Post, SUCCESS Magazine, AskMen.com, Electric Literature and The Wall Street Journal. His career also includes ghostwriting for Fortune 500 CEOs and published authors.Read More
- Financially Reviewed ByEbony J. Howard, CPA
Ebony J. Howard, CPA
Credentialed Tax Expert at Intuit
Ebony J. Howard is a certified public accountant and freelance consultant with a background in accounting, personal finance, and income tax planning and preparation. She specializes in analyzing financial information in the health care, banking and real estate sectors.Read More
- Published: October 4, 2021
- Updated: August 23, 2022
- 5 min read time
- This page features 9 Cited Research Articles
- Edited By
Are Annuities a Good Investment?
Annuities can be a useful financial product to secure a steady income in retirement. An annuity is a long-term contract between you and an insurance company in which the insurer provides you regular payouts in exchange for a lump sum or series of premiums.
Whether annuities are a good investment for you depends on your financial goals and resources.
If you already receive a large pension or have another substantial source of retirement income, purchasing an annuity may not be a good fit.
However, if you’re like many Americans and don’t have a guaranteed income stream in retirement other than Social Security, you may consider buying an annuity. Annuities protect against the risk of outliving your savings.
Annuity contracts can be customized and structured to meet your specific needs and goals.
- How often you want to receive annuity payouts (monthly, quarterly or annually)
- When your payments begin (now or in the future)
- How long you want payments to last (the rest of your life or a certain period)
- If payments will be made over one life or two lives (you and your spouse, for example)
- If you want a stepped-up death benefit for your annuity beneficiary
Annuities can be complex and they’re not for everyone. But like a pension or Social Security, annuities provide a way to supplement your living expenses in later life.
- Guaranteed source of income
- Tax-deferred growth
- Customizable features
- Difficult to access money ahead of schedule
- Surrender charges and fees apply
If you purchase an annuity and decide it’s not right for you, remember that many companies offer what’s known as a free look period. This time gives you a chance to review contract details and cancel the arrangement without penalty.
How Annuities Work by Type
Annuities come in many forms. Each offers its own unique advantages and disadvantages.
Exploring the different types of annuities is a smart way to identify which one fits your needs and risk tolerance.
All annuities are taxed deferred. You won’t owe taxes on earnings until the money in your account is distributed or withdrawn.
Annuities offer add-on features, known as riders, that supplement other benefits, such as lifetime payments for your spouse or extra funds to pay for long-term care. These benefits cost extra money.
How Fixed Annuities Work
Fixed annuities are a straightforward, no-frills option. They carry the lowest risk and lowest fees.
Fixed annuity payouts are based on an interest rate specified in your contract. Payouts aren’t affected by fluctuations in the stock market, so they can offer peace of mind for risk-averse investors who want to ensure money for later life.
How Variable Annuities Work
The size of variable annuity payments is tied to an underlying investment portfolio. You can choose from a range of investments. Mutual funds are the most common option.
Payments from variable annuities can increase if your subaccounts perform well but decrease if your investments lose money.
Variable annuities expose you to greater risk than fixed annuities, but they also allow you to reap the benefits of a strong market.
Variable annuities are the most complex annuity and typically carry the highest fees.
How Indexed Annuities Work
The size of your indexed annuity payments are tied to the performance of a broad market index, such as the S&P 500.
Indexed annuities let you benefit from gains in the stock market and guarantee a minimum rate of return no matter how poorly the market performs.
The value of an indexed annuity typically grows at a higher rate than a fixed annuity.
Annuities Versus Other Retirement Investments
Unlike other investments such as stocks, bonds or mutual funds, annuities allow you to transfer the risk of outliving your retirement savings to an insurance company.
Annuities can help diversify your portfolio. Their stable and relatively safe nature can balance other higher risk investments that fluctuate with the stock market.
- A 401(k) is a retirement savings account offered by employers. It invests your money in mutual funds, stocks and bonds. Both annuities and traditional 401(k) accounts defer taxes until the money is withdrawn. Contributing to a traditional 401(k) provides a tax deduction while annuity contributions do not.
- Mutual fund
- A mutual fund pools money from many people and invests it in stocks, bonds or other assets. The collection of holdings is known as the fund’s portfolio. Mutual funds and annuities both charge fees. Variable annuities often allow you to invest in mutual funds within the annuity’s subaccounts.
- Individual retirement account (IRA)
- A traditional IRA is a retirement investment account in which you purchase stocks, bonds, mutual funds or other assets to grow your retirement nest egg . Like annuities, withdrawals from traditional IRAs are fully taxable as income. The IRS levies a 10 percent penalty for withdrawals from annuities and IRAs before the age of 59.5. Annuities typically have higher fees than IRAs but don’t have annual contribution limits.
- Roth IRA
- Unlike its traditional counterpart, a Roth IRA deducts taxes when you deposit money in, but withdrawals come out tax-free in retirement. Roth IRAs also don’t face the same IRS penalties on withdrawals before the age of 59.5. If you use money from a Roth IRA to purchase an annuity, you will only be taxed on the earnings instead of the entire annuity withdrawal.
- Bonds and annuities are both considered fixed income assets, meaning they’re relatively safe and predictable. A bond is essentially a loan from an investor who receives regular interest payments from the borrower for a fixed time before the principal investment is returned. Both annuities and bonds establish specific payment dates, and in both cases, the issuer guarantees payments.
9 Cited Research Articles
- Internal Revenue Service. (2021, March 11). Roth 401(k), Roth IRA, and Pre-tax 401(k) Retirement Accounts. Retrieved from https://www.irs.gov/retirement-plans/roth-comparison-chart
- Napoletano, E. and Schmidt, J. (2021, March 29). Annuity Vs. 401(k): Understanding The Similarities And Differences. Retrieved from https://www.forbes.com/advisor/retirement/annuity-vs-401k/
- Wettstein, G., Munnell, A. H., Hou, W., et al. (2021, March). The Value of Annuities. Retrieved from https://crr.bc.edu/working-papers/the-value-of-annuities/
- Tepper, T. (2021, February 24). Times Have Changed: How To Save For Retirement Today. Retrieved from https://www.forbes.com/advisor/retirement/retirement-planning-annuity/
- Alliance for Lifetime Income. (2021). Majority of Gen X Investors Interested in Annuities, as 9 out of 10 Retirement Investors Look for Protected Income. Retrieved from https://www.protectedincome.org/prip/
- Carey, M. (2018, July 16). Bonds Or Annuities: What's The Best Way To Generate Retirement Income? Retrieved from https://www.forbes.com/sites/mattcarey/2018/07/16/bonds-or-annuities-whats-the-best-way-to-generate-retirement-income/?sh=6758468874d0
- U.S. Securities and Exchange Commission. (2005, October 15). Mutual funds. Retrieved from https://www.sec.gov/investor/tools/mfcc/mutual-fund-help.htm
- Financial Industry Regulatory Authority. (n.d.). Fixed Annuities. Retrieved from https://www.finra.org/investors/learn-to-invest/types-investments/annuities/fixed-annuities
- U.S. Securities and Exchange Commission. (n.d.). Annuities. Retrieved from https://www.investor.gov/introduction-investing/investing-basics/glossary/annuities
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