What is an annuity?

An annuity is a financial product offered by insurance companies to provide investors with a steady income stream in retirement. Investors make a lump sum payment or a series of payments, and the annuity pays a specific amount back to them in regular distributions either immediately or at some point in the future. These distributions can be used to cover essential or recurring expenses.

What are the different types of annuities?

The four most common kinds of annuities are immediate, deferred, variable and fixed.

  1. In an immediate annuity, you can begin taking payments from the account almost as soon as you open it.
  2. With a deferred annuity, you can’t withdraw income from the annuity for a couple years to even decades after you've funded the account – you save first, and then take income later.
  3. A fixed annuity has a guaranteed fixed interest rate, and your capital accumulates on a tax-deferred basis. Since fixed annuities don't begin paying out right away, they’re technically deferred annuities. But unlike a deferred income annuity, you can choose if and when to start receiving payments.
  4. A variable annuity is also tax-deferred. You can choose from a group of investments. Your payout in retirement is based on the performance of the investments you chose. It’s a variable payout, compared to a fixed annuity’s guaranteed payout.

There’s also a secondary group of annuities, which includes equity-indexed annuities, longevity annuities and retirement annuities:

  1. An equity-indexed annuity combines characteristics of a fixed and a variable annuity. You get a guaranteed minimum return, but since the return is tied to the performance of a benchmark index, you have the opportunity to enjoy higher gains if the stock market rises.
  2. A longevity annuity helps to protect against outliving your money in retirement. You have to wait until you reach age 80 or so to begin receiving a payout. Once the payout begins, the annuity provides a guaranteed, regular amount of income for the rest of your life. If you die before you begin to receive payments, your heirs do not receive the remainder of the annuity.
  3. A retirement annuity is an accumulation of retirement funds, something you invest money into while still actively working. Upon retiring, two-thirds of the value is used to buy an annuity that you can generate income from as a retiree.

What are some benefits of investing in annuities?

The primary benefit of investing in annuities is a guaranteed income source in the form of regular payments in or before retirement. Your contributions are tax-deferred, and annuities do not have a contribution limit or a required minimum distribution (RMD). Benefits include:

  • Guaranteed income source. For retirees and pre-retirees, a guaranteed income source reduces concerns about losing money from retirement savings in a downturn, or outliving retirement savings. With an annuity, you fund the account and typically earn a predetermined amount of interest, regardless of what happens in the stock market. However, this can be different with variable annuities.
  • Tax advantages. You can also defer taxes on the money you contribute to an annuity. Unlike other tax-deferred retirement savings accounts such as IRAs and 401Ks, there isn’t a contribution limit, a limit to how much you can put away each year. Annuities can provide a vehicle for tax-deferred savings if you have maxed out other retirement accounts.
  • No RMDs. Traditional retirement accounts require that you begin making withdrawals at age 70 ½. Retirement annuities, however, don't carry that same stipulation, meaning that the funds can continue to grow in the account until you need them.

What are some risks of investing in annuities?

Like any investments, annuities carry risks. For example, if you pass away before the payout period, you miss out on annuity payments. In addition, it may not be easy to take money out of your annuity account after you’ve invested it. Investors should research the insurance company that is underwriting the annuity. Risks include:

  • Missing the income benefit. The idea behind annuities is that you save money now to have an income stream for the rest of your life. If you suddenly pass away, you would miss out on that long-term benefit. Some annuities allow you designate a beneficiary, but it may come with an extra cost.
  • Tying up money you may need. Once you've invested your money in an annuity, it can be difficult to access it or cash it out if you suddenly need those funds. For example, some immediate annuities take away access to your principal after you have invested it, even though the payments begin right away. Others offer access to the principal or designate time periods in which you can take out larger amounts, but they may provide smaller monthly payments. Deferred annuities usually have a 10% penalty for making withdrawals before you turn 59 ½.
  • Insolvent insurance companies. Because an annuity is a long-term investment, you'll want to make sure the company you purchase it from is around for the long term. Investors should investigate the credibility, history and credit standing of potential annuity providers.

Considerations for annuity investors

Before investing in an annuity, consider any associated fees with the annuity, penalties for early withdrawals, how payouts are determined and what happens to the account if you pass away. In addition, annuity payments don't usually account for inflation, another factor to consider.

  • Not all annuities have high fees. Some annuities, known as direct-sold annuities, are sold by investment companies without a sales commission or surrender charge. You can purchase low-cost annuities from a variety of brokerage houses. A financial advisor can help provide more information.

  • For a fixed-rate annuity, the insurance company chooses the investments and agrees to pay you a predetermined fixed return. For a variable annuity, you decide how to invest your money in the sub-accounts offered within the annuity.

  • Some annuities allow you to assign a beneficiary for your account, but there can be a cost associated with doing so. Other annuities only pay out during your lifetime, and the payments stop when you die. Investigate the payout options regarding beneficiaries before you invest.

  • If you use pretax money to purchase an annuity, all payouts will be fully taxed. But if you purchase the annuity with after-tax dollars, a part of the payouts will be a tax-free return of your principal. In both cases, you must pay any taxes you owe on the annuity at your ordinary income-tax rate, not the preferable capital-gains rate.

  • If you buy an immediate annuity with after-tax money, you’ll be taxed only on the annuity’s earnings. A portion of every payout is considered a return of your original investment and is regarded as taxable earnings.

  • If an annuity’s payouts stop after death, the payment period is the IRS's life-expectancy number for someone your age. As a result, you owe taxes only on a portion of each payout beyond the tax-free return of principal.

  • If you buy an annuity with pretax money, the entire balance will be taxable. But if you use after-tax funds, you'll be taxed only on the earnings.

Other retirement vehicles

Annuities are just one way to save for retirement. Consider other vehicles as well, including: