What an annuity is and how you get paid

An annuity is a contract you buy from an insurance company. You give them a lump sum of money (or make payments over time), and in return they promise to pay you a set amount at regular intervals — usually monthly — for the rest of your life, or for a period you choose. The insurance company takes the money you give them, invests it, and uses the returns to fund your payments.

The basic mechanics are straightforward: you pay in, they pay out. But the details matter enormously. How much you receive each month depends on your age when you start, how much you paid in, current interest rates, and which type of annuity you chose. A 55-year-old who puts in $100,000 will receive different monthly payments than a 70-year-old with the same investment, because the insurance company expects to pay the younger person for longer.

Key Takeaways

  • An annuity converts a lump sum into may provide monthly payments for life or a set period, funded by an insurance company's investment of your money.
  • Fixed annuities pay the same amount every month regardless of market performance; variable annuities fluctuate based on how the underlying investments perform.
  • You lose access to your principal once you buy an annuity, so this strategy works best for money you won't need for emergencies or large expenses.
  • Annuities carry fees that reduce your returns, and some have surrender periods during which you cannot withdraw money without penalties.
  • An annuity is one tool among many for retirement income; whether it makes sense depends on your other savings, life expectancy, and how much may provide income you need.

Fixed annuities versus variable annuities

Fixed annuities pay you the same dollar amount every month for life (or your chosen period). The insurance company absorbs all investment risk. If markets crash, your payment stays the same. If markets soar, your payment still stays the same. You know exactly what you will receive. This predictability appeals to people who want to cover basic living expenses with money they can count on.

Variable annuities tie your payments to the performance of investments you choose — usually mutual funds. If those investments perform well, your payments increase. If they perform poorly, your payments decrease. You bear the investment risk. Variable annuities also typically cost more in fees because the insurance company is managing investment options and providing ongoing administrative support.

A third type, indexed annuities, sits between the two. Your payments are tied to the performance of a market index (like the S&P 500), but with a floor — your payment will not drop below a certain minimum, even if the index performs poorly. These are more complex and often carry higher fees than fixed annuities.

The immediate annuity versus the deferred annuity

An immediate annuity begins paying you within a year of purchase. You hand over a lump sum, and within months the monthly checks start. This is the simplest structure and is often used by people who have just retired and want to convert savings into income right away.

A deferred annuity is purchased years before payments begin. You might buy one at 55 and not start receiving payments until 70. During the deferral period, your money grows (either at a fixed rate or based on market performance, depending on the type). Deferred annuities are sometimes used as a long-term savings vehicle, though they are not tax-advantaged like retirement accounts.

What happens to your money and when you can access it

Once you buy an annuity, that money is no longer yours to access freely. Most annuities have a surrender period — typically 5 to 10 years — during which you cannot withdraw your money without paying a penalty. The penalty is usually a percentage of the withdrawal amount and decreases each year. If you need cash during this period, you may lose 5 to 10 percent or more of what you withdraw.

After the surrender period ends, you can usually withdraw money, but doing so may reduce your future monthly payments. Some annuities allow you to withdraw a small percentage each year without penalty, but this varies by contract. Read the fine print before you buy.

When you die, what happens to any remaining money depends on the type of annuity and the options you chose. A life-only annuity pays you for as long as you live, then stops — your heirs receive nothing. A period-certain annuity guarantees payments for a set number of years (say, 20 years); if you die before that period ends, your beneficiary receives the remaining payments. A life with period-certain annuity pays you for life, but guarantees a minimum payout period to your heirs. These options affect your monthly payment amount — the more protection you build in for your heirs, the lower your monthly check.

Fees and how they reduce your returns

Annuities are not free to own. Fixed annuities typically charge lower fees — often 0.5 to 1.5 percent annually — because the insurance company is simply managing the contract and paying you from a pool of investments. Variable annuities charge more: 1 to 3 percent or higher annually, because the insurance company is managing multiple investment options and providing ongoing support.

Beyond annual management fees, you may encounter surrender charges (if you withdraw early), mortality and expense risk charges (the insurance company's cost to may provide your payments), and administrative fees. Some annuities sold through brokers also include sales commissions, which can be 5 to 10 percent of your initial investment. That commission comes out of the money you give the insurance company, reducing what actually gets invested to generate your payments.

Over decades, these fees compound. A 1 percent annual fee on a $100,000 annuity costs $1,000 in year one, but over 20 years it can reduce your total payout by tens of thousands of dollars. Always ask for a breakdown of all fees before you commit.

Who annuities make sense for and who they do not

Annuities work best for people who have other savings to cover emergencies and unexpected expenses, and who want to convert a portion of their retirement savings into may provide monthly income. If you have $500,000 in retirement savings and want to lock in $2,000 per month for life to cover rent and utilities, an annuity can do that. You keep the rest of your money in investments or savings accounts for flexibility.

Annuities make less sense if you have limited savings, poor health, or expect to need access to your money. If you are 60 years old with $50,000 total and you put it all into an annuity, you have lost the ability to pay for a medical emergency or help a family member. If you have a condition that shortens your life expectancy, you may not receive enough payments to justify the fees and loss of access.

Annuities also do not make sense if you already have may provide income sources — Social Security, a pension, rental income — that cover your basic needs. Adding more may provide income may not improve your financial security; instead, you might benefit more from keeping your money invested for growth or flexibility.

Questions to ask before buying an annuity

Before you sign a contract, get clear answers to these questions: What is the total annual cost, including all fees and commissions? What is the surrender period, and what are the penalties? Can you withdraw a portion of your money penalty-free each year, and if so, how much? What happens to your money if you die before the payout period ends? How is the monthly payment calculated, and what assumptions about your life expectancy does it use?

Also ask whether the insurance company is rated highly for financial stability. An annuity is only as good as the company's ability to pay you decades from now. Check ratings from agencies like A.M. Best, Moody's, or Standard & Poor's. If the company fails, your payments are protected by state insurance guarantees, but those protections have limits (usually $100,000 to $250,000 per state, depending on where you live).

Consider getting a second opinion from a fee-only financial planner — someone who charges you directly for advice rather than earning commission on products they sell. They can help you decide whether an annuity fits your overall retirement plan or whether other strategies make more sense.

Frequently Asked Questions

Can I change my mind after I buy an annuity?

Most annuities have a free-look period of 10 to 30 days after purchase during which you can cancel and get your money back with no penalty. After that period ends, you are locked in. If you want out during the surrender period, you will pay a penalty. Read your contract to confirm the free-look period and the surrender schedule.

Are annuities taxed differently than other investments?

If you buy an annuity with after-tax money (not inside a retirement account), the portion of each payment that represents your original investment is not taxed again. The portion that represents earnings is taxed as ordinary income. If you buy an annuity inside an IRA or 401(k), all payments are taxed as ordinary income when you withdraw them. Consult a tax professional about your specific situation.

What if I need a large amount of money before the annuity payments start?

If you own a deferred annuity and face a hardship, some contracts allow you to withdraw money early, but you will pay surrender charges and possibly income tax on the earnings portion. Some annuities also offer a hardship waiver for specific situations like terminal illness or long-term care needs. Check your contract or call your insurance company to see what options exist.

How do I know if an annuity payment is fair for my age and investment?

Use an online annuity calculator to compare quotes from multiple insurance companies. Enter your age, the amount you plan to invest, and the type of annuity you want. Different companies will offer different monthly payments for the same investment because they use different assumptions about investment returns and life expectancy. Shop around before committing.