What happens when you buy an annuity

An annuity is a contract between you and an insurance company. You give the company a lump sum of money (or make payments over time), and in return, the company promises to pay you a stream of income — either when ready, later, or both. The insurance company invests your money and uses the returns to fund those payments to you.

The core trade-off is straightforward: you exchange a large amount of money today for smaller, predictable payments spread across months or years. The insurance company takes on the risk that you live longer than expected and must keep paying you. You take on the risk that you die sooner than expected and may not recover your initial investment.

How much you receive each month depends on your age when you start, how long the contract lasts, current interest rates, and the type of annuity you choose. A 65-year-old and a 75-year-old who invest the same amount will receive different monthly payments because the 75-year-old has fewer years ahead.

Key Takeaways

  • An annuity converts a lump sum into regular monthly or annual payments, with the insurance company bearing longevity risk.
  • when ready annuities begin paying you within a year; deferred annuities delay payments until a future date you choose.
  • Fixed annuities pay the same amount every period; variable annuities tie payments to investment performance and carry market risk.
  • Annuity payments are taxed as ordinary income, and withdrawals before age 59½ may trigger a 10% penalty plus income tax.
  • Annuities reduce your flexibility because most contracts do not let you access the full balance if you change your mind.

when ready vs. deferred annuities

An when ready annuity starts paying you within one year of purchase, usually within 30 to 90 days. You hand over your money, and the insurance company begins sending you checks. This type makes sense if you are already retired or about to be, and you want income to start right away.

A deferred annuity delays payments until a date you choose — often years in the future. During the waiting period, your money grows inside the contract, either at a fixed rate or tied to market performance. You might buy a deferred annuity at 55 and set it to start paying at 70, giving your money time to compound. The longer you wait to start payments, the larger each payment will be.

Deferred annuities are sometimes used as a tax-sheltered savings vehicle before retirement, similar to how a 401(k) works — your money grows without annual tax bills. However, when you finally withdraw or start receiving payments, you owe income tax on the gains.

Fixed annuities vs. variable annuities

A fixed annuity pays you the same dollar amount every month for life (or for a set number of years, depending on your contract). The insurance company guarantees this payment and bears the investment risk. If interest rates rise or fall, your payment stays the same. This predictability appeals to people who want to know exactly what they will receive and do not want to worry about market swings.

A variable annuity ties your payments to the performance of investments you choose — typically mutual funds or similar options inside the annuity. If those investments perform well, your payments increase. If they perform poorly, your payments fall. You take on the market risk instead of the insurance company. Variable annuities often come with higher fees because the insurance company is managing investment options and providing ongoing administration.

There is also a middle ground: indexed annuities tie payments to a market index (like the S&P 500) but with a cap on gains and a floor on losses. You might receive 80% of the index's gains but never lose more than 0% in a down year. These contracts are complex and often carry high fees.

How taxes work with annuities

Annuity payments are taxed as ordinary income at your regular tax rate, not at the lower capital gains rate. If you bought the annuity with pre-tax money (from a 401(k) rollover, for example), the entire payment is taxable. If you bought it with after-tax money, only the earnings portion is taxable; the part that represents your original investment comes back tax-free.

The insurance company will send you a 1099-R form each year showing how much of your payment is taxable. You report this on your tax return. If you withdraw money from a deferred annuity before age 59½, you owe income tax on the withdrawal plus a 10% penalty — unless an exception applies (such as disability or a series of substantially equal periodic payments).

One tax advantage of annuities is that money inside the contract grows without triggering annual tax bills. Unlike a regular investment account, where you pay tax each year on dividends and capital gains, an annuity defers those taxes until you withdraw or receive payments. This can be useful if you are in a lower tax bracket in retirement than you are now.

Surrender charges and access to your money

Most annuity contracts include a surrender period — typically 5 to 10 years — during which you cannot withdraw your full balance without paying a penalty. If you need your money back early, the insurance company charges a surrender fee, which is a percentage of the withdrawal amount. This fee starts high (sometimes 7% or more in year one) and declines each year until the surrender period ends.

Some annuities allow you to withdraw a small amount each year — often 10% of your balance — without penalty. Others let you withdraw without penalty if you enter a nursing home or face a terminal illness. Read the contract to understand what flexibility you have.

This lack of liquidity is a major drawback. If you buy an annuity and then face an unexpected expense or change your mind about your retirement plan, you may be stuck paying a steep fee to access your own money. This is why financial advisors often recommend annuities only for money you are confident you will not need to touch.

Annuity riders and add-ons

Insurance companies sell riders — optional add-ons that modify the basic contract. Common riders include a death benefit (ensuring your heirs receive a minimum amount if you die early), a cost-of-living adjustment (increasing your payment each year to keep pace with inflation), or a long-term care rider (providing extra money if you need nursing home care).

Each rider increases the cost of the annuity by reducing your monthly payment or requiring an upfront fee. A cost-of-living rider, for example, might reduce your starting payment by 15% to 20% to account for future increases. You need to weigh whether the protection is worth the cost.

Some riders are valuable — a cost-of-living adjustment can matter a lot over 30 years of retirement. Others are expensive relative to what they deliver. Before you buy, ask the insurance company to show you the payment difference with and without each rider you are considering.

When an annuity makes sense in your tax picture

An annuity can be a useful tool if you have a large lump sum (from a pension payout, inheritance, or 401(k) rollover) and want to convert it into may provide lifetime income. It locks in current interest rates and removes the temptation to spend the money all at once.

Annuities also make sense if you are concerned about outliving your savings. If you live into your 90s, an annuity that pays you for life will eventually deliver more total income than you put in — something you cannot predict with a regular investment portfolio.

However, annuities are usually not the right choice if you need access to your money, expect to leave a large inheritance, or are uncomfortable with the high fees and complexity. They are also less attractive if you are in a high tax bracket now and expect to be in a lower one in retirement — in that case, deferring income through other means (like delaying Social Security or using tax-loss harvesting) may save you more in taxes.

Frequently Asked Questions

Can I get my money back if I change my mind about an annuity?

Most states require a free-look period of 10 to 30 days after you buy an annuity, during which you can return it and get your full money back. After that period ends, you can still withdraw, but you will owe a surrender fee if you are still in the surrender period. The fee declines each year and eventually disappears.

What happens to my annuity if I die before payments start?

If you die during the accumulation phase of a deferred annuity, your beneficiary typically receives the balance of your account. If you die after payments have started, what your beneficiary receives depends on your contract — some annuities stop paying entirely, while others continue for a set period or pay a lump sum. Review your contract to see what you chose.

Are annuities safe if the insurance company fails?

Insurance companies are regulated by state insurance commissioners, and most states have a guaranty fund that protects annuity holders if an insurer becomes insolvent. Coverage limits vary by state but are typically $250,000 or more per person per company. Check your state's insurance department website for the exact limit in your state.

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

Buying an annuity inside a 401(k) or IRA makes sense because the account already offers tax deferral — the annuity's tax shelter is redundant. Buying an annuity outside a retirement account can be useful if you have maxed out your retirement contributions and want additional tax-deferred growth, but the fees are often high enough to offset the tax benefit.

How do annuity fees compare to other investments?

Annuities typically charge 1% to 3% per year in management fees, plus surrender charges if you withdraw early, plus fees for any riders you add. A low-cost index fund might charge 0.05% per year. The higher cost of an annuity is the price of the insurance company's may provide and the loss of liquidity — you are paying for certainty and longevity protection, not just investment management.