What Is an Annuity and How Does it Work?

·7 min read

An annuity is a contract made with an insurance company that guarantees an income stream for the owner of the annuity or annuitant. That stream of income can be paid out immediately or in the future, depending on the type of annuity.

Table of contents

  • How do annuities work?

  • Are annuities right for you?

  • How to buy an annuity

  • Summary of Money’s guide to annuities

How do annuities work?

Annuities are a type of investment where the owner of the annuity or annuitant pays a lump sum amount or series of premium payments that the insurer invests in the stock market.

Just like the investment component of permanent life insurance, the funds in your annuity account grow tax-deferred.

Once you have accumulated sufficient funds in your account, you can annuitize those premiums and begin receiving a series of payments. That income stream can be paid out weekly, quarterly, annually or as a lump sum payment.

You can choose the payment amount, frequency, and duration of your annuity payment, but that may also depend on the type of annuity account in which your funds are held and how long your funds have been invested.

If you’re interested in learning more about other insurance products, read our guide to the best life insurance companies.

Types of annuities

In general, there are three main types of annuities. The differences between annuity products lie in how the funds are invested and when the income stream is paid out.

Fixed annuity

As the name suggests, a fixed annuity offers a fixed rate of return and regular payments. Your state insurance commissioner regulates this type of annuity.

Variable annuity

With variable annuities, you can invest in different funds, such as mutual funds. Your income stream will then depend on how much you invest and the rate of return of those investments. Variable annuities are better suited for investors with higher risk tolerance and regulated by the Securities and Exchange Commission.

Indexed annuity

Indexed annuity payments are tied to a stock market index, like the S&P 500. An indexed annuity does well when the market is performing well. Indexed annuities are considered a hybrid between fixed and variable annuities.

Differences between immediate annuities and deferred annuities

Immediate or deferred refers to how quickly you can start receiving payments from your annuity.

  • Immediate annuity: You can start receiving payments as soon as you invest funds in the annuity. This option makes sense for people nearing retirement age or that unexpectedly received a large sum of money.

  • Deferred annuity: You invest your funds for a longer period and receive payments at a future date. This option makes sense if you want to receive an income stream after retirement.

What is annuitization?

Annuitization is the process of converting funds into a regular income stream. For example, you can annuitize a large sum of money — such as a death benefit or lottery winnings — to receive payments for a specific period or a lifetime.

Annuitization can also refer to the period during which you’re receiving annuity payments. This commonly occurs after the “accumulation phase,” the period during which an annuity account is being funded.

How are annuities taxed?

An annuity is a tax-deferred investment. When you buy an annuity with pre-tax funds, any annuity payments you receive are taxable as income. However, when you purchase an annuity with after-tax dollars, you’re liable to pay taxes on any earnings.

If you choose to withdraw funds from your annuity before the age of 5 ½, you may have to pay a 10% tax penalty to the IRS on top of applicable income taxes.

Are annuities right for you?

A life insurance annuity may be right for older adults looking for a guaranteed income during retirement without taking on as much risk as they would by investing in the stock market.

Some annuity options may also benefit younger adults who want to turn a large sum of money into an income stream, as their longer life expectancy would allow for more significant interest gains.

Here are some of the pros and cons of annuities:

Pros of annuities

Cons of annuities

Provide guaranteed income for a predetermined period of time.

A portion of your annuity income could be taxable.

Are suitable for long-term investment goals such as retirement planning.

You may be subject to a 10% IRS tax penalty if you withdraw money from your annuity before the age of 59 ½.

Interest rates remain stable, even in unpredictable market conditions.

Have a lower rate of return than other investment options.

Putting a large sum in an annuity can help prevent mismanagement and prematurely exhausting funds.

There may be an additional charge or fee if you need to sell a variable annuity or withdraw from it before a certain period.

Your investments are tax-deferred.

The funds in your account aren’t FDIC insured.

According to Howard Sharfman, senior managing director at NFP Insurance Solutions, investing in the stock market could give you a higher rate of return than investing in an annuity — and with fewer fees and penalties.

However, the right move for you will depend on your risk tolerance and retirement plan. Speak to a certified financial planner (CFP) before determining if an annuity is right for you.

How to buy an annuity

You can purchase an annuity directly from a life insurance company, but some banks, insurance brokers and mutual fund companies also sell them.

Some 401k plans and Individual Retirement Accounts (IRAs) also allow participants the option to invest some of their retirement savings in annuity subaccounts.

However, we highly recommend you consult a CPF or financial advisor before deciding to do that, as annuities may have charges and penalties and offer no additional tax deferral.

Before you purchase an annuity, make sure to do the following:

  1. First, read the annuity contract thoroughly and understand what you’re getting into.

  2. If you opt for a variable annuity, make sure to read the prospectuses of all the mutual funds you plan to invest in.

  3. Make sure you’re doing business with a reputable annuity company or broker registered to sell annuities. Of course, the same goes for any other insurance product.

Annuities FAQ

Is a life insurance annuity a good investment?

For people with a low risk tolerance looking to supplement their retirement income, annuities are worth considering, says legal-financial field expert John Blair.

For most people, though, annuities may not be a good investment. Other traditional investing accounts have higher rates of return and fewer fees and penalties than annuities.

Can you lose money in an annuity?

You can lose money in an annuity, depending on the type of annuity it is.

Fixed annuities have a fixed rate of return, so they're the safest annuity option. Indexed annuities also have a guaranteed rate of return, but it only applies to a portion of your premium payments.

The other portion of your returns are tied to the performance of an index, but there is typically a cap on how much you can earn or lose.

Variable annuities are the riskiest annuity option because you're investing in stocks, bonds and mutual funds. If your investments perform poorly, they may lose value.

How much does a $100,000 annuity pay per month?

Over a fixed 10-year period and at current rates, a $100,000 traditional annuity would pay out $871.37 each month for ten years.

Blair explains that accounting for current interest rates at about 0.5-2.5%, the total payout after ten years would be $104,564.40.

What happens to the money in a life insurance annuity when you die?

Some annuities end after the death of the annuitant. However, annuities with a death benefit provision will continue paying out an income stream to any named beneficiaries.

What is the surrender period of an annuity?

The surrender period refers to the timeframe during which an annuitant cannot withdraw from or sell an annuity without incurring a penalty or "surrender charge."

The surrender period can span from six to eight years.

Summary of Money’s guide to annuities

  • Annuities can provide you ordinary income for a number of years or the rest of your life.

  • You can receive lifetime income through regular weekly or monthly annuity payments.

  • Annuities can also pay out quarterly, annually or as a single lump sum.

  • Annuities let you convert a lump sum payment such as a death benefit or lottery winnings into regular income payments.

  • Annuity withdrawals and earnings may be taxable.

  • Depending on your risk tolerance, you can invest in fixed, variable or indexed annuities, which have different rates of return.

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