Annuity Definition & Guide — Types, How They Work, Taxes, Pros & Cons

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Annuity Definition & Guide — Types, How They Work, Taxes, Pros & Cons

Annuity
Annuity



What is an annuity? 

An annuity is a contract sold by an insurance company where an individual pays one or more premiums (a lump-sum or periodic payments) in exchange for a series of future payments from the insurer. Those payments can begin immediately or be deferred to a later date, and they may be fixed, variable, or indexed to market performance. Annuities are primarily used to create a steady retirement income and to hedge the risk of outliving one’s savings.

Key quick takeaways

How an annuity works — purpose, phases, and regulation

Purpose. People buy annuities mainly to secure predictable retirement income and reduce longevity risk (the risk of outliving assets). Because annuities trade liquidity for cash flow certainty, they’re best suited for those who don’t need full access to their capital and who value predictable payments.

Phases.

  1. Accumulation phase: You fund the annuity via a lump sum or recurring premiums. Money grows tax-deferred.

  2. Annuitization/payout phase: You start receiving regular payments for a fixed term or life (or a combination).

Immediate vs. deferred.

  • Immediate annuity: You pay a lump sum and receive payments shortly thereafter (often used by people with a windfall).

  • Deferred annuity: Money grows tax-deferred until payments begin at a specified later date (good for longer-term retirement planning).

Regulation.

  • Fixed annuities: Regulated by state insurance commissioners (not the SEC).

  • Variable and registered indexed annuities: Regulated by the SEC and FINRA (since they include securities).
    Agents selling annuities typically must hold state life-insurance licenses and securities licenses for variable products. Because of tax and product complexity, Investopedia warns readers to consult a professional before purchase.

Other important considerations (surrender periods, withdrawals, and riders)

Surrender period and charges. Most annuities include a surrender period during which withdrawals above a permitted annual free amount (commonly ~10%) trigger a surrender charge. Surrender periods can last several years; penalties typically decline over time. Early withdrawals may also trigger income tax and a possible 10% IRS early-withdrawal penalty if taken before age 59½.

Selling or lumping out. Some annuitants facing liquidity needs sell their future payments (through a secondary market) in exchange for a lump sum — effectively selling the income stream at a discount. This can provide cash but reduces lifetime income.

Income riders. Optional riders can guarantee a minimum lifetime income, add inflation protection, or provide enhanced payouts for impaired health. Riders often carry extra fees; investors should ask about rider costs and the age at which income begins. Riders let some buyers receive lifetime income without fully annuitizing (so they retain control of the account).

Fast fact. Defined-benefit pensions and Social Security are effectively lifetime annuity payments provided by employers and the U.S. government.

Annuities in workplace retirement plans

Employers can offer annuities inside qualified plans (401(k), 403(b)), though historically these were rare because annuities are complex. The SECURE Act of 2019 made it easier for employers to include annuity options in workplace plans by loosening some rules and offering safe-harbor protections for selecting providers — potentially increasing their use. (Note: employers must still weigh complexity, costs, and fiduciary duty.)

Types of annuities — full breakdown

Immediate vs. Deferred (timing)

  • Immediate annuity: Payments start almost right away after a lump-sum payment.

  • Deferred annuity: Payments start at a future date you choose; money accumulates tax-deferred in the meantime.

Fixed, Variable, and Indexed (investment/return structure)

  • Fixed annuities: Provide a guaranteed minimum interest rate and fixed periodic payments. Good for risk-averse buyers who want predictable income.

  • Variable annuities: Money is invested in sub-accounts (similar to mutual funds); payouts vary with investment performance. They have market risk and potential for loss of principal, but can offer higher returns if markets perform well. Variable annuities are regulated as securities.

  • Indexed (equity-indexed) annuities: Returns are linked to an index (e.g., S&P 500) but usually include a downside protection floor and caps or participation rates. They blend fixed and variable features and have complex crediting formulas.

Additional structures and riders

  • Survivorship (Joint & Survivor) annuity: Continues payments to a spouse (or survivor), often at a reduced level after the primary annuitant dies.

  • Life with period-certain: Guarantees payments at least for a minimum period (e.g., 10 or 20 years); if the annuitant dies early, remaining payments go to beneficiaries.

  • Qualified Longevity Annuity Contract (QLAC): A deferred annuity bought inside a retirement account (IRA/401(k)) that defers required minimum distributions (RMDs) on part of the balance until an advanced age. QLACs aim to provide longevity insurance.

Calculating present and future value (concepts to know)

Investopedia links related concepts: present-value and future-value annuity calculations, annuity tables, and the Present Value Interest Factor of an Annuity (PVIFA). These formulas show how lump-sum amounts compare to streams of periodic payments and help determine whether an annuity offer is actuarially fair given interest rates, life expectancy, and payout terms. (If you need formulas or worked examples, those are commonly provided in dedicated mathematics sections.)

Tax implications — qualified vs. nonqualified, penalties, and ordering rules

Qualified vs. non-qualified annuities.

  • Qualified annuity: Funded with pre-tax dollars inside a retirement account (401(k), IRA); withdrawals are taxed as ordinary income.

  • Non-qualified annuity: Funded with after-tax dollars; only earnings are taxable when withdrawn — contributions (principal) are not taxed again.

Tax ordering rules. Withdrawals from non-qualified annuities generally follow a “last in, first out” rule (earnings are treated as withdrawn first and taxed as ordinary income). Early withdrawals (before age 59½) may be subject to a 10% IRS penalty on taxable earnings, in addition to regular income tax.

Other tax notes. Variable annuities are treated as securities for regulation, but their tax treatment is similar to other annuities; special IRS rules (e.g., Publication 575) provide guidance. A 1035 exchange lets you move cash value from a life policy or annuity into another contract without immediate tax consequences if done correctly.

Payouts, distributions, and withdrawals (options & rules)

Choosing a payout. Payout options include lifetime payments, joint & survivor, or fixed-period payments. The choice affects the monthly/annual amount — lifetime payouts tend to be higher than joint payouts for the same premium because they stop at death.

RMDs and rollovers. Variable annuities inside qualified accounts may be subject to required minimum distributions (RMDs) depending on account type. You can sometimes roll over variable annuities into IRAs, but rules and tax consequences vary. For inherited annuities, distribution options depend on beneficiary rules and whether the annuity is qualified or non-qualified.

Penalties & borrowing. Surrender charges apply during the surrender period. Some contracts permit loans or partial withdrawals but may charge interest or reduce death benefits. Borrowing features vary by contract and provider.

Benefits (why people buy annuities)

Risks & criticisms (what to watch out for)

Regulatory note. The 2024 U.S. Retirement Security Rule (DOL) was designed to tighten fiduciary obligations on financial professionals advising retirement savers; litigation and industry pushback may affect how annuities are sold and compensated. This is a live regulatory area; consult current guidance when making choices.

Annuity vs. Life Insurance — the difference

While both products are sold by insurers and can be used together, their purposes differ:

  • Life insurance protects against premature death by paying a death benefit to beneficiaries.

  • Annuities protect against longevity risk by converting assets into a stream of income for the owner’s lifetime (or a chosen term). The cash value of a permanent life insurance policy can sometimes be exchanged for an annuity via a tax-free 1035 exchange.

Examples

  • Immediate annuity example: You pay $200,000 in a single premium and receive $5,000 a month for a fixed period or for life — the precise payment depends on prevailing interest rates and mortality assumptions.

  • Fixed annuity illustration: You buy a deferred fixed annuity with a guaranteed minimum interest rate and later annuitize to receive stable payments.

Who typically buys annuities?

People near or in retirement who want predictable income, and those with low liquidity needs, commonly buy annuities. Younger individuals or people needing flexible access to funds are usually advised to consider alternatives because annuities reduce liquidity and can be costly to exit early.

FAQ — short answers to common questions (from Investopedia)

Q: Are annuities taxed?
Yes — earnings are taxable as ordinary income when withdrawn; tax treatment differs for qualified vs. non-qualified annuities.

Q: Do you get your principal back?
It depends. With a straight lifetime payout, no; with term or period-certain options, remaining principal may be paid to heirs. Riders or death benefits can alter outcomes.

Q: Can annuities be part of a 401(k)?
Yes. The SECURE Act made it easier for employers to offer annuity options inside workplace plans, though uptake is mixed due to complexity and provider selection concerns.

The bottom line

Annuities are insurance contracts designed to turn capital into a predictable income stream, especially useful for retirees who want lifetime payments and protection from longevity risk. They come in many shapes (immediate/deferred, fixed/variable/indexed) and are governed by complex rules, fees, and tax implications. Annuities can be valuable tools when used appropriately, but they require careful scrutiny — compare product details, fees, surrender terms, and insurer strength, and consult a fiduciary advisor before buying. 


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