An annuity is a contract with an insurance company that turns a sum of money into regular payments

You give an insurance company a lump sum of money — or make payments over time — and in return, the company promises to pay you a set amount at regular intervals for a period you choose. That period might be a fixed number of years, or it might be for the rest of your life. The insurance company takes your money, invests it, and uses the returns to fund your payments.

Annuities are sold by insurance companies, not banks or investment firms, though you may buy one through a financial advisor or broker. They are most commonly used by people nearing or in retirement who want to convert savings into a predictable income stream. The trade-off is that once you sign the contract, you typically cannot get your money back in a lump sum, and you lose control of the principal.

Key Takeaways

  • An annuity converts a one-time payment or series of payments into regular income over a set period or for life.
  • You purchase an annuity from an insurance company, which invests your money and pays you back with interest over time.
  • The main types are fixed annuities (predictable payments), variable annuities (payments tied to investment performance), and indexed annuities (payments tied to a market index).
  • Annuities lock your money away — you cannot withdraw the full amount early without penalties, and fees can be substantial.
  • Annuities are most useful for people who want may provide lifetime income and have other savings they can access for emergencies.

How you fund an annuity and when payments begin

You can fund an annuity in two ways. An when ready annuity is purchased with a lump sum, and payments begin within a year — often within a month. You hand over the money, and the insurance company starts sending you checks. This is common for people who have just retired or received a large settlement.

A deferred annuity is funded over time or with a lump sum, but payments do not start until a date you choose in the future — sometimes years away. During the waiting period, your money grows, either at a fixed rate (if it is a fixed annuity) or tied to market performance (if it is variable or indexed). Deferred annuities are often used by younger workers who want to build retirement income gradually.

Fixed, variable, and indexed annuities: the three main types

Fixed annuities pay you the same amount every month or quarter for the life of the contract. The insurance company guarantees the rate of return, so you know exactly what you will receive. This predictability appeals to people who want no surprises, but the trade-off is that your payments do not increase with inflation, so their purchasing power shrinks over time.

Variable annuities tie your payments to the performance of investment accounts you choose — usually mutual funds. If the market performs well, your payments can increase. If it performs poorly, your payments can decrease. You have more upside potential than with a fixed annuity, but you also carry the investment risk. Variable annuities typically come with higher fees because the insurance company is managing investment options for you.

Indexed annuities sit between the two. Your payments are tied to the performance of a market index — such as the S&P 500 — but the insurance company sets a floor (a minimum return) and a cap (a maximum return). You get some upside if the market rises, but you are protected if it falls. These are sometimes called fixed indexed annuities.

What happens to your money after you buy an annuity

Once you sign the contract and hand over your money, the insurance company owns it. They invest it in bonds, stocks, or other securities depending on the type of annuity you chose. The returns from those investments fund your payments. You do not manage the investments yourself — the insurance company does.

If you need access to your money before the contract term ends, you will face a surrender charge — a penalty that can range from 5 to 10 percent of your withdrawal, sometimes higher in the early years. Some annuities allow you to withdraw a small percentage each year without penalty, but most lock your money away. This is why financial advisors recommend only putting money into an annuity that you will not need for emergencies.

Fees and costs you need to understand

Annuities are not free to own. Fixed annuities typically have lower fees — often just the insurance company's administrative costs, which may be built into the rate they quote you. Variable and indexed annuities charge more: mortality and expense fees (usually 1 to 1.5 percent per year), investment management fees (0.5 to 2 percent per year depending on the funds you choose), and sometimes rider fees if you add features like a may provide income floor or death benefit.

You may also pay a commission to the person who sold you the annuity — typically 5 to 10 percent of your purchase price. This commission comes out of your money, not from a separate fee you see on a statement. Always ask what the total annual cost is before you buy, and request a written breakdown of all fees.

Who benefits most from an annuity

Annuities work best for people who have already saved enough to cover emergencies and unexpected expenses, and who want to convert a portion of their savings into may provide income. They are useful if you are worried about outliving your savings, because a life annuity pays you for as long as you live, no matter how long that is.

Annuities are less useful if you need access to your money, if you have significant debt, or if you are young and have a long time horizon before retirement. They are also less attractive if you are in poor health, because you may not live long enough to recover the money you put in — though some annuities offer a death benefit that pays your heirs if you die early.

Annuities versus other retirement income sources

Social Security is a form of annuity — the government pays you a set amount for life based on your earnings record. The difference is that you do not buy Social Security; you earn it through payroll taxes. An annuity is a product you purchase from a private company.

Pensions, which some employers still offer, are similar to annuities in that they pay you a set amount for life. But you do not buy a pension; your employer funds it. With an annuity, you are the one putting up the money.

A bond ladder — buying bonds that mature at different times — can provide similar income without locking your money away, but it requires more active management and does not protect you against living longer than expected. An annuity shifts that longevity risk to the insurance company.

Frequently Asked Questions

Can I change my mind after I buy an annuity?

Most annuities have a free-look period of 10 to 30 days after purchase, during which you can return the contract and get your money back with no penalty. After that window closes, you are locked in. If you withdraw money early, you will pay a surrender charge.

What happens to my annuity 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. The protection limit varies by state but is typically $100,000 to $250,000 per person per company. Check your state's insurance commissioner website for the exact amount.

Do I pay income tax on annuity payments?

Yes. If you funded the annuity with pre-tax money (like a rollover from a 401(k)), all payments are taxable as ordinary income. If you funded it with after-tax money, only the earnings portion is taxable. The insurance company will send you a 1099-R form each year showing how much is taxable.

Can I leave my annuity to my heirs?

It depends on the contract. Some annuities end when you die, and any remaining balance goes to the insurance company. Others include a death benefit that pays your heirs a set amount or your remaining balance, whichever is greater. You choose this when you buy the annuity, and it affects your payment amount.

What is the difference between an annuity and life insurance?

Life insurance pays your heirs a lump sum when you die. An annuity pays you income while you are alive. Some products combine both features, but they serve opposite purposes: insurance protects against dying too soon, while an annuity protects against living too long.