An annuity is a contract with an insurance company: you hand over money, either all at once or over time, and the insurer promises to pay you income later, often for the rest of your life. Annuities can protect you from running out of money in retirement, but many come with high fees and long lock-up periods.
How an annuity works
An annuity has two phases. In the accumulation phase, your money grows tax-deferred. In the payout phase, the insurer pays you a stream of income, for a set number of years or for life. The guarantee is only as strong as the insurance company behind it, so check its financial strength rating.
Main types of annuities
| Type | How it grows | Best for |
|---|---|---|
| Fixed annuity | Guaranteed interest rate | Safety, similar to a CD |
| Fixed indexed annuity | Linked to an index like the S&P 500, with caps and a floor | Some upside with no market losses |
| Variable annuity | Invested in funds; can rise or fall | Rarely the best choice due to fees |
| Immediate annuity (SPIA) | Pays income starting within a year | Retirees who want a paycheck now |
| Deferred income annuity | Income starts years later | Insurance against living very long |
Pros
- Guaranteed income you cannot outlive, like a private pension.
- Tax-deferred growth, with no annual contribution limit.
- Peace of mind if you worry about market crashes in retirement.
Cons
- Fees: variable annuities can cost 2% to 3% a year once riders are added, far more than an ETF.
- Surrender charges: taking money out early, often within 7 to 10 years, can cost a fee of several percent.
- Taxes: gains are taxed as ordinary income, not lower capital gains rates, and withdrawals before 59½ can face a 10% penalty.
- Inflation: fixed payments lose buying power unless you pay for an inflation rider.
- Complexity: sales commissions can push products that do not fit you.
Who should consider an annuity
A simple immediate annuity can make sense for retirees who have already maxed out low-cost options, want a guaranteed floor of income on top of Social Security, and are worried about living into their 90s. It is usually a poor fit for younger savers, who are better served by a 401(k), an IRA and index funds.
Planning your retirement income? Start with how much you need to retire and the 4% rule.
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Frequently asked questions
Can you lose money in an annuity?
In a fixed or fixed indexed annuity, not from market drops, but surrender charges and inflation can still cost you. Variable annuities can lose value.
What happens to an annuity when you die?
It depends on the contract. Some stop paying, while others pay a beneficiary or guarantee payments for a set period.
Are annuities FDIC insured?
No. They are backed by the insurer and, up to limits, by state guaranty associations.
This article is general information, not financial or tax advice.
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