An annuity is a contract with an insurance company where you give them a lump sum of money now, and they pay you back in regular installments over time

The insurance company holds your money, invests it, and sends you checks monthly, quarterly, or annually for a period you choose in advance. You might receive payments for a set number of years — say, 10 or 20 — or for the rest of your life. The longer the company expects to pay you, the smaller each payment will be. In exchange for taking on the risk that you live longer than expected, the insurance company keeps whatever money remains if you die before the contract ends.

Annuities are sold by insurance companies, not banks. You buy them through an insurance agent, a financial advisor, or sometimes directly from the company. They are not government-backed and not insured by the FDIC, though most insurance companies are regulated by your state's insurance commissioner and backed by a state guaranty fund that protects you if the company fails.

Key Takeaways

  • You pay the insurance company a sum of money upfront, and they return it to you in scheduled payments over months, years, or your lifetime.
  • The amount of each payment depends on your age, how long you want payments to last, current interest rates, and the insurance company's costs and profit margin.
  • Annuities come in three main types — when ready, deferred, and variable — each with different timing and investment structures.
  • You will pay surrender charges if you withdraw money early, and you may owe income tax on the gains when you receive payments.
  • An annuity is a contract between you and one insurance company; if that company fails, your state's guaranty fund provides limited protection.

The three main types of annuities and how they differ

when ready annuities start paying you within one year of purchase. You hand over a lump sum — often from a pension payout, inheritance, or retirement account — and the insurance company begins sending you checks right away. These are straightforward: you know exactly how much you will receive each month for the life of the contract. There is no investment risk to you because the insurance company has already locked in the rate.

Deferred annuities delay payments. You contribute money now, it grows tax-deferred inside the contract, and payments begin at a date you choose — often years later, such as at retirement. During the growth phase, you do not receive income; instead, your balance accumulates. When the payout phase starts, you receive regular payments just like an when ready annuity. Deferred annuities appeal to people who want to set aside money now and live off it later.

Variable annuities tie your payments to the performance of investment accounts you choose — typically mutual funds holding stocks, bonds, or both. Your payment amount fluctuates based on how those investments perform. If the market rises, your payments may increase; if it falls, they may decrease. Variable annuities carry investment risk that when ready and deferred fixed annuities do not. They also charge higher fees because the insurance company must manage the underlying investments.

What determines how much you receive each month

The insurance company uses a formula that accounts for your age, your life expectancy, current interest rates, and how long you want the payments to last. A 65-year-old will receive larger monthly payments than a 55-year-old who buys the same annuity, because the company expects to pay the younger person for longer. If you choose payments for life, the company spreads your lump sum across your expected remaining years; if you choose a 10-year payout, the same lump sum produces larger monthly checks because the company pays out faster.

Interest rates matter significantly. When interest rates are high, insurance companies can earn more on the money you give them, so they can afford to pay you more each month. When rates are low, your monthly payment shrinks. The insurance company also deducts its costs and profit margin from what it pays you — this is how they make money on the contract.

You cannot change the payment amount once the contract begins, except in variable annuities where the amount changes automatically based on investment performance. Some annuities offer a cost-of-living adjustment rider that increases your payment by a set percentage each year, but this costs extra and reduces your starting payment.

Surrender charges and early withdrawal penalties

Most annuities impose a surrender charge if you withdraw money before a set date — typically 5 to 10 years after purchase. This charge is a percentage of the amount you withdraw, often starting at 7 or 8 percent and declining by 1 percent each year. If you need your money back after three years of a seven-year surrender period, you might lose 4 percent of the withdrawal amount to the charge. After the surrender period ends, you can usually withdraw without penalty, though you may still owe income tax on any gains.

The IRS also imposes a 10 percent penalty tax on withdrawals from annuities before age 59½, on top of regular income tax. This rule applies to money you contributed and to earnings. Some exceptions exist — for example, if you are disabled or taking substantially equal periodic payments — but they are narrow and require documentation.

Surrender charges exist because the insurance company locks in a rate when you buy the annuity. If interest rates rise after you purchase, the company has committed to paying you a lower rate than it could charge new customers. The surrender charge protects the company from losing money if you leave early.

Taxes on annuity payments and growth

How you are taxed depends on what type of account funded the annuity. If you bought an annuity with after-tax money from a savings account, you pay income tax only on the earnings portion of each payment, not on the return of your own contribution. If you funded it with money from a traditional IRA or 401(k), the entire payment is taxable as ordinary income because that money was never taxed when you contributed it.

During the growth phase of a deferred annuity, you do not pay tax on earnings each year the way you would with a regular investment account. Tax is deferred until you withdraw or begin receiving payments. This can be an advantage if you are in a lower tax bracket in retirement, but it is not unique to annuities — IRAs and 401(k)s offer the same deferral.

When you receive payments, the insurance company will send you a 1099-R form showing how much is taxable. You report this on your tax return. If you withdraw a lump sum instead of taking payments over time, the entire taxable portion is reported in the year of withdrawal, which can push you into a higher tax bracket.

Fees and commissions built into annuities

Annuities are not free to buy or own. Insurance agents typically earn a commission of 5 to 10 percent of your purchase price, paid by the insurance company. This commission is built into the contract and reduces what you effectively receive. Some annuities also charge annual management fees, mortality and expense charges, or administrative fees — these are deducted from your account value or your payments.

Variable annuities charge the most because they involve investment management. You might pay 1 to 3 percent annually in fees, plus the underlying mutual fund fees, which can total 2 to 4 percent or more per year. when ready and fixed deferred annuities typically have lower ongoing fees because the insurance company is straightforward managing a pool of money and paying out a fixed amount.

Before you buy, ask the insurance company or agent for a detailed breakdown of all charges. Some companies publish this in a document called a prospectus or fact sheet. Compare the net payout — what you actually receive after all fees — across different companies, not just the headline payment amount.

What happens to your money if the insurance company fails

Insurance companies are regulated by your state's insurance commissioner, and most states require companies to maintain reserves to cover their obligations. If an insurance company fails, your state's insurance guaranty fund steps in to protect you. These funds are not government-run; they are funded by assessments on other insurance companies in the state.

Guaranty fund protection has limits. Most states cover up to $250,000 per person per insurance company for annuity contracts. If your annuity is worth more than that, the excess may not be protected. Some states offer higher limits for certain types of annuities. Check your state's insurance commissioner website to learn the exact limits in your state.

The guaranty fund does not protect you from poor investment performance in a variable annuity or from the insurance company's decision to lower rates on new contracts. It protects you only if the company becomes insolvent and cannot pay what it owes.

Frequently Asked Questions

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

Most states require a "free look" period of 10 to 30 days after purchase during which you can return the annuity and receive a full refund. After that period ends, you can withdraw money but will owe surrender charges and possibly income tax. Read the contract to find the exact free look period for your annuity.

Is an annuity the same as a pension?

An annuity is a contract you buy; a pension is a benefit your employer provides. However, when a company offers you a lump sum from your pension, you can use that money to buy an annuity, which then provides you with regular payments similar to a pension. Many people do this to convert a one-time payout into lifetime income.

What if I die before the annuity payments end?

It depends on the contract terms. Some annuities pay only while you live; if you die, payments stop and any remaining balance goes to the insurance company. Others include a death benefit that pays your beneficiary a set amount or the remaining balance. These options are chosen when you buy the annuity, so review your contract to know what applies to yours.

Can I use money from my 401(k) or IRA to buy an annuity?

Yes. You can roll over funds from a 401(k) or IRA into an annuity without triggering when ready taxes, as long as you follow the rollover rules. However, the 10 percent early withdrawal penalty still applies if you are under 59½ and do not meet an exception. Consult a tax professional before rolling over retirement funds.

Do annuities keep up with inflation?

Standard annuities pay a fixed amount each month, so inflation erodes the purchasing power of your payments over time. Some annuities offer a cost-of-living adjustment rider that increases payments by a set percentage annually, but this costs extra and reduces your starting payment. Without this rider, your monthly check stays the same even as prices rise.