Annuities are insurance products that trade upfront money for may provide payments later, but they come with high fees and lock-in periods that make them wrong for most investors

An annuity is a contract with an insurance company: you give them a lump sum (or make payments over time), and they promise to pay you a fixed amount each month for the rest of your life, or for a set number of years. The appeal is simple — you cannot outlive the income. The catch is equally simple — you pay heavily for that may provide through fees, surrender charges if you need your money back, and returns that often lag behind what you could earn elsewhere.

Whether an annuity makes sense depends entirely on your situation: your age, how much money you have, whether you already have a pension, and how much certainty you actually need. For most working-age investors, annuities are a poor choice. For some retirees with large sums and no other may provide income, they can fill a real gap — but only if you understand what you are paying and what you are giving up.

Key Takeaways

  • Annuities charge 1 to 3 percent annually in fees, plus surrender charges of 5 to 10 percent if you withdraw money in the first 5 to 10 years, making them expensive compared to index funds or bonds.
  • The payments you receive are taxed as ordinary income, not capital gains, which means a higher tax bill than you would pay on stock dividends or bond interest.
  • Once you buy an annuity, your money is locked in — you cannot access it without penalties, and you cannot change your mind if rates rise or your circumstances shift.
  • Annuities make the most sense for people over 70 with a large sum they do not need immediately and no pension, because the may provide income replaces what Social Security does not cover.
  • For younger investors or anyone with less than $100,000 to invest, a mix of low-cost index funds and bonds usually delivers better returns and more flexibility.

How annuity fees eat into your returns

An annuity's stated interest rate is not what you actually earn. Insurance companies layer on multiple fees that reduce your real return. A typical annuity charges 1 to 3 percent per year in management and insurance fees alone. On top of that, many annuities include surrender charges — penalties of 5 to 10 percent if you withdraw more than a small amount in the first 5 to 10 years. Some annuities also charge riders (add-ons for features like inflation protection or death benefits) that cost another 0.5 to 1.5 percent annually.

Compare this to a low-cost index fund, which charges 0.03 to 0.20 percent per year. Over 20 years, that difference compounds dramatically. A $100,000 investment in an index fund earning 7 percent annually with 0.10 percent in fees grows to roughly $380,000. The same $100,000 in an annuity earning 5 percent (after fees) grows to roughly $265,000. You lose more than $100,000 in growth simply because of how the product is structured.

Tax treatment: ordinary income, not capital gains

When you withdraw money from an annuity, the earnings portion is taxed as ordinary income at your full tax rate — up to 37 percent federally, plus state tax. This is different from stocks or bonds held in a regular account, where long-term gains are taxed at lower rates (0, 15, or 20 percent federally depending on income). If you hold an annuity inside a retirement account like an IRA, this does not matter because everything in an IRA is taxed as ordinary income anyway. But if you buy an annuity with after-tax money, the tax bill is steep.

Some annuities offer tax-deferred growth, meaning you do not pay taxes on earnings until you withdraw. This sounds good, but it only helps if you do not withdraw for many years — and most annuities penalize early withdrawal anyway. If you need the money before age 59½, you also face a 10 percent early withdrawal penalty on top of income tax (unless you are already retired).

The lock-in problem: what happens if you need your money

Once you buy an annuity, your money is not easily accessible. If you need to withdraw more than the small annual amount most contracts allow (usually 10 percent), you pay a surrender charge. These charges start high — often 7 to 10 percent in year one — and decline by 1 percent per year until they disappear after 7 to 10 years. If you surrender the contract early, you get back less than you put in, even if the underlying investment has grown.

This matters because life circumstances change. You might face a medical emergency, lose your job, or realize you need access to capital. With an annuity, you are stuck. With a regular investment account, you can sell and access your money within days. The inflexibility is a real cost, even if you never actually need to withdraw early.

When annuities might actually make sense

Annuities are most useful for people in a specific situation: age 70 or older, with a large sum of money (usually $200,000 or more), no pension, and a need for may provide monthly income beyond what Social Security provides. If you fit this profile, an annuity can convert a lump sum into income you cannot outlive, which has real psychological and financial value.

A deferred income annuity (DIA) or may have access to longevity annuity contract (QLAC) can be particularly useful in this case. A DIA lets you buy an annuity now and delay payments until age 80 or 85, locking in today's rates while you live off other savings. A QLAC is a special type of annuity you can buy inside a retirement account with up to $135,000 (as of 2023), which lets you defer required minimum distributions and create may provide income later.

Even in these cases, you should buy only what you need for basic expenses — not your entire nest egg. Keep the rest in liquid investments so you retain flexibility and can leave money to heirs if you die early.

Alternatives that usually work better

For most investors, a combination of low-cost index funds and bonds delivers better returns, lower fees, and more flexibility. An index fund tracking the S&P 500 or total stock market costs 0.03 to 0.10 percent annually and has no surrender charges. A bond fund or Treasury ladder provides stable income without locking you in. You can rebalance as your needs change, access your money if you need it, and leave whatever remains to your heirs.

If you want may provide income but do not want an annuity, consider a Treasury ladder — buying Treasury bonds that mature in different years so you receive regular payments. This gives you certainty without the fees or lock-in. You can also delay claiming Social Security until age 70, which increases your monthly benefit by 8 percent per year — a form of may provide income that is often better than an annuity for most people.

For retirees who want some may provide income but not all of it locked in, a partial annuity strategy works well: buy a small annuity to cover essential expenses (housing, food, utilities) and keep the rest invested for growth and flexibility. This gives you peace of mind without the all-or-nothing commitment.

Questions to ask before buying an annuity

If you are seriously considering an annuity, get the full fee breakdown in writing before you commit. Ask for the annual management fee, any surrender charges and how long they last, the cost of any riders, and the real rate of return after all fees are deducted. Compare that number to what you could earn in a low-cost index fund or bond fund. If the annuity does not beat the alternative by a meaningful margin, it is not worth the loss of flexibility.

Also ask whether the annuity is fixed (payments stay the same) or variable (payments change based on market performance). Fixed annuities are simpler but offer lower returns. Variable annuities expose you to market risk while still charging high fees — the worst of both worlds. Ask about inflation protection: a fixed annuity paying $2,000 per month today will buy less in 20 years, so some people add a rider that increases payments over time (at a cost).

Frequently Asked Questions

Can I get my money back if I change my mind?

Most states have a "free look" period of 10 to 30 days after you buy an annuity, during which you can cancel and get your full money back. After that period ends, you can still withdraw, but you will pay a surrender charge — typically 5 to 10 percent in the first year, declining over time. The contract specifies exactly when charges end.

What happens to my annuity if the insurance company fails?

State insurance regulators oversee annuity companies, and most states have a guaranty fund that protects annuity holders up to a certain amount (usually $250,000 to $500,000 per company) if an insurer becomes insolvent. Check your state's insurance department website for the exact limit. This protection is real but not unlimited, so buying from a large, stable insurer reduces risk.

Is an annuity better than keeping money in a savings account?

Yes, an annuity will almost always pay more than a savings account, which currently earns 4 to 5 percent. But a high-yield savings account is liquid and has no fees or lock-in, making it better if you might need the money. For money you truly will not touch for years, a bond fund or index fund will beat an annuity's returns after fees.

Should I buy an annuity inside or outside a retirement account?

Outside a retirement account (like an IRA or 401k), annuities are tax-inefficient because earnings are taxed as ordinary income. Inside a retirement account, everything is taxed as ordinary income anyway, so the tax disadvantage disappears. If you are considering an annuity, buying it inside a retirement account makes more sense.

Can I use an annuity to leave money to my heirs?

Standard annuities stop paying when you die, so your heirs get nothing. Some annuities offer a "period certain" option, guaranteeing payments for a set number of years even if you die — any remaining payments go to your heirs. This costs extra and reduces your monthly payment. For most people, a regular investment account is a better way to build wealth to leave behind.