The four main types of annuities and how they differ

An annuity is a contract with an insurance company where you give them a lump sum or make payments over time, and they promise to pay you income later — usually for life or a set number of years. The type of annuity you hold determines how much that income will be, whether it changes, and what happens to your money if you die before collecting it all.

There are four broad categories: fixed annuities, variable annuities, indexed annuities, and when ready annuities. The first three describe how your money grows before you start taking payments. The fourth describes when you start taking payments. Many annuities combine features from more than one category — for example, you might own a fixed when ready annuity or a variable deferred annuity.

Understanding the difference matters because each type carries different risks and returns. With a fixed annuity, the insurance company takes the investment risk. With a variable annuity, you do. An indexed annuity splits the risk between you and the insurer.

Key Takeaways

  • Fixed annuities may provide a set payment amount for life, but your income does not rise with inflation and the insurer keeps any investment gains above what they promised you.
  • Variable annuities let your payments grow based on how the underlying investments perform, but they can also fall, and you pay higher fees for this flexibility.
  • Indexed annuities tie your returns to a stock market index like the S&P 500, but with a cap on how much you can gain and a floor that protects you from losses.
  • when ready annuities begin paying you within one year of purchase, while deferred annuities let your money grow for years before payments start.
  • The type you choose depends on whether you want may provide income, growth potential, or a mix of both.

Fixed annuities: may provide income, no market risk

A fixed annuity is the simplest type. You give the insurance company a sum of money, and they promise to pay you a specific dollar amount each month or year for the rest of your life, or for a period you choose. That payment never changes, no matter what happens in the stock market.

The insurance company invests your money in their own bond portfolio and keeps any returns above what they promised you. This is why fixed annuities are safe — the insurer absorbs the investment risk. Your income is backed by the insurance company's financial strength, not by market performance.

The trade-off is that your payments are fixed in dollar terms. If inflation rises to 4 percent per year and your annuity pays you $2,000 a month, that $2,000 buys less each year. Some fixed annuities offer a cost-of-living adjustment (COLA) rider that increases your payment by a set percentage each year, but this reduces your starting payment amount.

Variable annuities: Growth potential tied to your investment choices

A variable annuity lets you direct your money into investment subaccounts — similar to mutual funds — that hold stocks, bonds, or both. Your payment amount depends on how those investments perform. If your subaccounts earn 8 percent in a year, your account grows by 8 percent. If they lose 5 percent, your account shrinks by 5 percent.

This means your future income is not may provide. It can be higher than a fixed annuity if markets perform well, or lower if they do not. You bear the investment risk, not the insurance company.

Variable annuities typically come with a may provide minimum income benefit (GMIB) rider. This promises that no matter how poorly your investments perform, you will receive at least a minimum payment amount when you start taking income. This protection costs extra — variable annuities charge higher fees than fixed annuities, often 1 to 3 percent per year in addition to the underlying fund expenses.

Indexed annuities: Capped gains with downside protection

An indexed annuity (also called an equity-indexed annuity) ties your returns to a stock market index like the S&P 500, but with limits on both gains and losses. This is a middle ground between fixed and variable annuities.

Here is how the limits work. The insurance company sets a participation rate — say, 80 percent. If the S&P 500 rises 10 percent in a year, your account grows by 8 percent (80 percent of 10 percent). The insurer keeps the extra 2 percent. If the index falls 10 percent, your account does not fall at all — the insurer absorbs the loss, down to a floor, usually zero or negative 3 percent. You cannot lose money in most indexed annuities, but you also do not capture the full upside of a bull market.

Indexed annuities appeal to people who want market exposure without the risk of a variable annuity, but they are more complex than fixed annuities. The participation rate, cap, floor, and measurement period (monthly, annual, or over the full contract term) all affect your actual returns, and these terms vary widely between products.

when ready versus deferred: When you start receiving payments

These categories describe timing, not how your money grows. An when ready annuity begins paying you within one year of purchase — often within a month. You hand over a lump sum, and the insurer starts sending you checks right away. when ready annuities are usually fixed, because you do not have time for your money to grow before payments begin.

A deferred annuity lets your money grow for years or decades before you start taking payments. During this growth phase, your account value accumulates based on whether you own a fixed, variable, or indexed annuity. Once you reach the age or date you choose, you convert that accumulated value into a stream of income. Most variable and indexed annuities are deferred.

You can own a deferred annuity for 10, 20, or 30 years before taking a single payment. This long growth period is why deferred annuities appeal to younger workers saving for retirement. when ready annuities appeal to people already retired who want to convert savings into may provide income right now.

may have access to and non-may have access to annuities: Tax treatment matters

An annuity is may have access to if you buy it with pre-tax money from a retirement account like a traditional IRA or 401(k). It is non-may have access to if you buy it with after-tax money from a regular savings or brokerage account.

This distinction affects how your payments are taxed. With a may have access to annuity, the entire payment is taxed as ordinary income when you receive it, because you never paid income tax on the money going in. With a non-may have access to annuity, only the earnings portion of each payment is taxed — the part of your payment that came from investment gains. The part that came from your original contribution is not taxed again.

Both types are subject to a 10 percent early withdrawal penalty if you take money out before age 59½, with some exceptions. Non-may have access to annuities have no contribution limits, while may have access to annuities are limited by the annual contribution caps of the retirement account they sit in.

Annuity riders: Add-ons that change how the contract works

An annuity rider is an optional add-on that modifies the basic contract. Common riders include death benefits (which may provide your heirs receive a minimum amount if you die before collecting all your payments), long-term care riders (which increase your payment if you need nursing home or home care), and income riders (which lock in a may provide income amount even if your account value falls).

Each rider adds cost — typically 0.5 to 1.5 percent per year in additional fees. Before buying an annuity, understand which riders come standard and which are optional. A rider that sounds valuable may not be worth the cost if you do not expect to use it.

Frequently Asked Questions

Can I switch from one type of annuity to another?

You can exchange one annuity for another under Section 1035 of the tax code without triggering a taxable event, but you must do this through a direct transfer between insurance companies. You cannot cash out and reinvest without tax consequences. Check your current contract for surrender charges, which may explore if you exit early.

Which type of annuity is best for retirement?

That depends on your age, risk tolerance, and income needs. Fixed annuities suit people who want predictable income and do not want to monitor investments. Variable annuities suit younger retirees who can tolerate market swings and want growth potential. Indexed annuities suit people who want some growth but prefer downside protection. Many retirees own a mix of all three.

What happens to my annuity if the insurance company fails?

Each state has a guaranty association that protects annuity holders if an insurer becomes insolvent. Coverage limits vary by state but typically range from $100,000 to $500,000 per person per insurer. Check your state's insurance commissioner website for the exact limit in your state.

Do I have to take payments for life, or can I take a lump sum?

Most annuities let you choose how to receive your money. You can take a lifetime income stream, a fixed number of years, or a lump sum. Some contracts penalize lump-sum withdrawals, especially in the early years. Review your contract's payout options before you buy.

Are annuities a good way to save for retirement?

Annuities are one tool among many. They excel at converting savings into may provide lifetime income, which is hard to replicate with stocks and bonds alone. But they carry high fees, surrender charges, and complexity. Compare the cost and features of any annuity against lower-cost alternatives like index funds before deciding.