What is an annuity and how does it work? Definition, types, and more
- Annuities are investment product issued by an insurer that provides steady income during retirement.
- An annuity charges a premium upfront with other management fees often rolled into the cost.
When putting away money for retirement, it can be difficult to know if you're saving enough. Even if you think you've got it all covered, there's little certainty about how much you'll actually spend or how long you'll live after you're through working.
That's where annuities come in. These unique combinations of insurance and investment features help investors save for retirement and offer assurance they won't outlive their hard-earned savings.
Learn more about annuities below and what you'll want to take into consideration before you add them to your portfolio.
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What is an annuity?
An annuity is an investment you buy in exchange for periodic payouts, typically during retirement.
"You generally put a lump sum or multiple payments into an account with an insurance company and you make a contract with them. The promise is that they're going to pay you a certain amount. It could be a lifetime benefit or a 10-year benefit," says Jordan Gilberti financial planner and senior lead planner at Facet.
People can purchase annuities using either pre-tax or after-tax dollars from select insurance companies, banks, brokerage firms, and mutual fund companies.
"There are multiple kinds of annuities. But they're all going to have some drawbacks and disadvantages that make them not necessarily suitable for everyone," stated Gilberti.
With non-qualified annuities (aka annuities bought with after-tax dollars), only investment gains are taxed at the time of withdrawal so you won't be taxed on the original contribution amount. Qualified annuities, on the other hand, are annuities bought with pre-tax dollars so the entire withdrawal amount will be taxed.
What is an annuity fund?
Annuity funds are investment portfolios, similar to mutual funds, that you're contributing money toward in the hope of earning gains. The money you've purchased your annuity with is often invested in fairly low-risk securities like corporate or government bonds.
That says, a variable annuity fund tends to be more volatile as it invests in riskier money market funds, mutual funds, and other market-based investments.
How annuities work
A modern-day annuity is a contract between you and an insurance company. To get an annuity, you'll need to pay a premium — usually a large lump sum — and then the insurer invests it. Afterward, the insurer provides you with a stream of payouts for a predetermined number of years or even the remainder of your lifetime.
An annuity has two phases:
- the accumulation phase: The accumulation phase of an annuity is the period when you're making payments. Those funds may be split among various investment options.
- the annuitization phase: The annuitization phase is the period when you receive payouts from the annuity, much like a regular paycheck. This can last for a set amount of years or the rest of your life. The payouts include the principal amount along with any investment gains.
Annuities provide a stable investment option for savers who worry about market volatility or outliving their retirement savings.
Annuities: Pros and cons
| Pros | Cons |
| Guaranteed retirement incomePayouts last through your lifetimeTax-deferred growth | Typically high feesNo short-term access to variable annuity fundsTax penalties on early withdrawal |
At their core, annuities are full of advantages:
- Reliable income for a set amount of time. Once you've made your payments, you're guaranteed to receive payouts for the rest of your life or someone else's life, like your spouse.
- Death benefits. You may also designate a beneficiary on your annuity. This beneficiary will receive the payouts if you die beforehand.
- Tax-deferred savings. Before you start receiving payouts, annuity income and investment gains grow tax free.
Unfortunately, there are major drawbacks to consider as well:
- Big fees. Annuities typically have high fees and commissions which can really cut back on the long-term earning potential. Because of this, annuities aren't a great place to grow money, but fixed immediate annuities take a smaller fee hit while generating a lifetime income stream.
- Illiquidity. Variable annuities have limited liquidity and don't offer access to your money until after several years, typically six to eight years but sometimes longer. If you do withdraw funds or cancel your annuity contract before that surrender period ends, you incur a surrender fee that can initially reach as high as 10% of your contributed funds, decreasing by one percentage point each consecutive year. Once your payouts start, it's next to impossible to change them or access more of your principal.
- Taxable income and tax penalties. Annuities aren't totally tax-free. As a source of income, annuity payouts are subject to income tax as you receive them. If you withdraw from your annuity before you're 59 ½, you'll face a 10% penalty on top of your ordinary income tax as well.
"Typical annuities have some disadvantages, like a lack of flexibility, lack of investment options, and a lot of times you have to make the trade-off of getting potentially higher returns to get those guaranteed payments," says Gilberti.
Types of annuities
Different types of annuities vary in how your money is invested and the level of risk involved.
Fixed annuities
Fixed annuities place your money in a general account (often through an insurance provider), which promises a minimum rate of interest and a fixed amount of periodic payouts. The premiums for fixed annuities are invested in high-quality, low-risk fixed securities such as bonds
Although fixed securities pose less risk compared to more volatile stocks or mutual funds, you won't generate as many gains as you would with a variable annuity. However, most fixed annuities do include a guaranteed minimum interest rate.
Before investing in a fixed annuity, make sure that your state insurance commission confirms your insurance broker, bank, or lender is registered to sell fixed annuities.
Variable annuities
Variable annuities place your money in various investments, much like a 401(k), and are directly linked to the stock market's performance.
The payouts from variable annuities fluctuate depending on how much money you pay, the rate of return on your investments, and any expenses of those investments as well as the annuity. Although you'll be at more risk of losing your money, variable annuities offer a greater return potential.
You can divvy up your premium in multiple subaccounts to invest in different sectors of the market. Variable annuity funds can be invested in assets like stocks, bonds, mutual funds, money market funds, and more.
Variable annuities are regulated by the Securities and Exchange Commission (SEC).
Indexed annuities
Index annuities provide the positive investment potential that variable annuities offer. The return of an index annuity is based on a stock market index, like the S&P 500. Like fixed annuities, these are regulated by state insurance commissioners.
Just like with a variable annuity, indexed annuities often have complex and hefty fees, such as surrender fees (also referred to as surrender charges). Surrender fees are imposed on policyholders if they cancel.
Payouts: Immediate annuities vs. deferred annuities
You can choose to buy an annuity that makes deferred payouts at some point in the future, or one that makes immediate payouts.
Immediate annuities
Also known as a single premium immediate annuity (SPIA), this option has payouts ready to start in as short as a month. It is typically purchased as a one-time lump sum. The insurance company then calculates the amount due to you based on your age, prevailing interest rates, and how long the payouts are expected to continue.
It's your call if you want an income stream for a limited period or a lifetime, and if you want monthly, quarterly, or yearly payouts. In general, the amount you receive for the whole period of your contract is fixed and guaranteed.
Deferred annuities
The deferred payment annuity option, as the name implies, delays the payouts until a future date. You can buy a deferred plan with a one-time payment or add to your funds periodically. After a length of time of your choosing — usually several years — you elect for payouts to begin.
The tax situation is more complicated, but basically, your principal — the money you initially invested — gets returned to you free of taxes. You'll only owe the IRS on the earnings your annuity made during the deferred period.
Tax treatment of annuities
One of the best perks of investing in annuities is how it is taxed. "Annuities complement other retirement plans in that they provide opportunities to grow without heavy taxation," says Rob Williams, managing director of financial planning, retirement income, and wealth management at Charles Schwab.
Annuities are tax-deferred, meaning you won't pay taxes on the initial contribution or the investment gains until you withdraw. Keep in mind, however, that if you decide to purchase your annuity with after-tax dollars, then you'll pay tax on the investment gains when you receive payouts.
Payouts are also subject to your regular income tax rate. If you're living in a high-tax state like California or New York, you may benefit from deferring some of your income and moving to a lower-tax or tax-free state to potentially pay less in income tax later on.
Annuity fees
In addition to the premium payments you make, you'll likely face some fees as well. Annuity fees typically range between 1% and 3%. An annuity with fees on the higher end of that range may not be a solid investment as they can take a hefty chunk out of your earnings.
- Mortality and expense risk charge pays the annuity issuer for the risk it's taking on for offering the annuity. This charge equals a percentage of your annual account value, often around 1.25% annually
- Administrative fees are charged by the issuer to cover the cost of record keeping and managing your annuity. It can be charged as a flat annual fee or a percentage of your account value.
- Commission fees often contribute to an annuity's price and exist to pay the person who sold it to you. This may drive an annuity's price up. You can likely avoid annuity commissions by buying from a fee-only advisor, who is paid only by you, and, as a fiduciary, is required to act in your best interests.
- Fund expenses are the costs that come with the funds your annuity may invest in, like mutual funds.
- Additional feature fees come with optional features you can add onto your annuity, such as guaranteed minimum income benefit or long-term care insurance.
- Penalties apply if you withdraw from an annuity before you're 59 ½. The Internal Revenue Service will levy a 10% tax penalty on top of regular income taxes you owe for the withdrawal amount.
- Surrender charges apply to variable annuities when you sell or withdraw money during the annuity's surrender period, often six to eight years after buying the annuity. Early withdrawals may also trigger unexpected tax hits, making variable annuities better for long-term goals.
Quick tip: Annuities can be a great way to supplement your existing savings by investing after retirement, along with Social Security payments. Fixed annuities also avoid the ups and downs of market investing.
Annuities — Frequently asked questions (FAQs)
Are annuities still a good investment?
Annuities may be good investment options for retirees worried they'll spend their savings too quickly. While not an ideal investment product to build wealth, annuities do have the potential to accrue value when invested in securities like fixed-rate bonds or variable money market funds.Who should not buy an annuity?
Younger individuals saving for retirement or paying down debt shouldn't buy an annuity, as annuities are better for older folks nearing retirement. Rather than purchasing an annuity, you can contribute a portion of your monthly income in tax-advantaged retirement savings accounts like 401(k)s and IRAs to benefit from compound interest and additional investment gains.Can you lose money in an annuity?
You may lose money in an annuity if you purchase a variable annuity. A variable annuity poses a higher risk than a fixed-rate annuity since it's more closely linked to the market. However, there is potential for greater returns with a variable annuity.How much monthly income can I expect from an annuity?
The monthly income you can expect from an annuity can vary depending on how much your premium was, the kind of annuity, if the funds were invested — including the amount of gains accumulated— and how many payments were predetermined. The amount you receive per month may also be affected by taxes and fees.Who should buy an annuity?
Annuities are a great addition to your retirement savings plan if you're always maxing out your 401(k) contributions and if you can afford the fees. They provide steady income throughout your retirement, they grow tax-free (until you receive payouts), and your beneficiaries can benefit from the payouts, too.
Since annuities aren't free, however, be sure to weigh their costs against their promised benefits to determine whether it's the right choice for you.
Chat with a financial consultant or CFP about your individual financial situation to see if an annuity is the right choice for you.