What Is an Annuity? Types, Pros, Cons & When to Buy One
An annuity is a contract between you and an insurance company where you make a lump-sum payment or series of payments in exchange for regular income disbursements, either immediately or at a future date. Annuities convert savings into a predictable income stream, typically used to supplement retirement income, and come in fixed, variable, and indexed varieties with different risk-return profiles and fee structures.
How Does an Annuity Work in Practice?
You purchase an annuity from an insurance company by depositing money—either a single premium (one lump sum) or multiple payments over time. During the accumulation phase, your money grows tax-deferred through interest credits or investment returns, depending on the annuity type.
What Are the Main Types of Annuities?
Fixed annuities guarantee a minimum interest rate (often 1-3%) and predictable payments; the insurer bears the investment risk. Your principal is protected, and you know exactly what you'll receive each period.
What Are the Pros of Owning an Annuities?
Tax-deferred growth allows your account to compound without annual 1099 forms until you withdraw, similar to an IRA but without annual contribution limits. Guaranteed lifetime income eliminates longevity risk—you cannot outlive your payments, a critical hedge if you lack a traditional pension.
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What Are the Cons and Costs of Annuities?
High fees erode returns: variable annuities charge mortality and expense risk fees (1-1.5% annually), administrative fees (0.1-0.3%), underlying fund expenses (0.5-1.5%), and rider fees (0.5-1% per rider), totaling 2-4% per year. Surrender charges penalize early withdrawals, locking up liquidity when you might need access.
When Should You Consider Buying an Annuity?
Annuities make sense when you've maximized tax-advantaged accounts (401(k), IRA, HSA), need guaranteed income to cover fixed expenses in retirement, fear outliving your savings, or want a pension substitute. Consider them after age 50-55 when the tax-deferral window is long enough to offset fees and surrender periods align with your liquidity needs.
FAQ
Can you lose money in an annuity?
Yes, in variable annuities your account value fluctuates with the underlying investments, and you can lose principal if markets decline. Fixed and indexed annuities typically protect principal from market losses, but surrender charges and fees can reduce your account value if you withdraw early or if the contract's costs exceed credited interest.
Are annuity payments taxable?
Gains are taxable as ordinary income when withdrawn. If you funded the annuity with after-tax dollars, each payment is part principal (tax-free return of basis) and part earnings (taxable); the IRS exclusion ratio determines the split.
How much does a $100,000 annuity pay per month?
A 65-year-old purchasing a $100,000 immediate fixed annuity might receive roughly $500-600 per month for life (single life, no period certain), depending on current interest rates and the insurer's pricing. Joint-life payouts are lower (perhaps $450-550), and adding a 10-year period certain reduces the monthly amount further.
What happens to an annuity when you die?
During accumulation, most annuities pay the account value or premium (whichever is higher) to your named beneficiary, who pays ordinary income tax on the gain. Once annuitized, payouts depend on your election: life-only stops at death; period-certain continues to beneficiaries for the remaining guaranteed years; joint-life continues to a surviving spouse.
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What the retirement calculator can estimate
A retirement savings calculator projects how current savings and future contributions might grow under a chosen return assumption. It can also estimate a potential retirement balance or test how long a balance may support planned withdrawals. Because actual investment returns vary, compare several scenarios instead of treating one result as certain. Include workplace accounts such as a 401k, individual accounts, taxable investments, and any pension benefits that apply.
Effective retirement planning also considers inflation, taxes, health expenses, debt, and the timing of Social Security or pension income. Full retirement age is a Social Security term and is not necessarily the age when someone must stop working. An annuity may create a contractual income stream, but fees, guarantees, liquidity restrictions, and insurer claims-paying ability depend on the specific product. Review assumptions regularly as income and expenses change.
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