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

You buy an annuity by paying a lump sum or a series of payments to an insurance company. In return, the company promises to send you money at regular intervals — monthly, quarterly, or annually — for a set period or for the rest of your life. The amount you receive each time depends on how much you paid in, your age, current interest rates, and the type of annuity you chose.

Annuities are most common as a way to turn a large amount of money (often from a pension, inheritance, or retirement account) into a steady income stream you cannot outlive. They are sold by insurance companies, not banks, and they are not the same as savings accounts or bonds, even though they serve a similar purpose of generating income.

Key Takeaways

  • An annuity converts a lump sum of money into regular payments spread over months, years, or your lifetime.
  • You purchase an annuity from an insurance company, not a bank, and the contract is legally binding on both sides.
  • Fixed annuities pay the same amount every period; variable annuities pay amounts that change based on investment performance.
  • when ready annuities start paying you within a year; deferred annuities delay payments until a future date you choose.
  • Annuities have fees, surrender charges if you withdraw early, and tax consequences that vary by the account type holding them.

Fixed annuities versus variable annuities

A fixed annuity pays you the same dollar amount every period for as long as the contract lasts. The insurance company guarantees this payment and bears the investment risk. If you buy a fixed annuity for $100,000 and it pays you $500 per month, you will receive $500 every month regardless of what happens in the stock market or the economy. This predictability makes fixed annuities popular with people who want stable income they can count on.

A variable annuity ties your payments to the performance of investments you choose — typically mutual funds or stock and bond portfolios. If those investments perform well, your payment increases. If they perform poorly, your payment decreases. Variable annuities shift investment risk to you, but they offer the possibility of higher returns if markets rise. They are more complex than fixed annuities and usually carry higher fees.

Some annuities are indexed annuities, which sit between fixed and variable. Your payment is tied to the performance of a stock market index (like the S&P 500), but with a floor — you will not lose money even if the index drops. These are less common and often have higher fees than fixed annuities.

when ready annuities and deferred annuities

An when ready annuity begins paying you within one year of purchase, usually within one to three months. You hand over a lump sum, and the payments start almost right away. when ready annuities are straightforward: you know the payment amount upfront, and there is little to manage after purchase. They are often used by people who have just retired or received a large sum and need income to start flowing when ready.

A deferred annuity delays payments until a future date you specify — sometimes years or decades away. During the waiting period, your money grows (either at a fixed rate or based on investments, depending on the type). Deferred annuities are often purchased earlier in retirement or even before retirement, as a way to lock in a may provide income stream that will not begin until later. They can also be used to grow money tax-deferred inside a retirement account.

How much you pay and what you receive

The amount you receive from an annuity depends on several factors. The most obvious is how much you pay in — a larger purchase price means larger payments. Your age at the time you buy also matters: the older you are, the higher your monthly payment, because the insurance company expects to pay you for fewer years. Current interest rates affect the calculation too; when rates are higher, annuity payments are higher because the insurer can earn more on the money you give them.

The type of annuity and how long it lasts also change the payment. A life annuity pays you for as long as you live, no matter how long that is. A period-certain annuity pays for a fixed number of years (like 10 or 20 years), and then stops. A joint-and-survivor annuity continues paying your spouse or beneficiary after you die. Each option produces a different monthly payment amount, and you choose which trade-off makes sense for your situation.

Fees and surrender charges

Annuities are not free to own. Insurance companies charge mortality and expense fees (usually 0.5% to 1.5% per year of your account value) to cover their costs and profit. Variable annuities often charge additional investment management fees on top of that, ranging from 0.5% to 2% per year depending on the funds you choose. These fees are deducted from your account or your payments automatically.

Most annuities also include a surrender period — typically 5 to 10 years after purchase — during which you cannot withdraw your money without paying a penalty. If you need to access your cash before the surrender period ends, you may lose 5% to 10% of your withdrawal amount. After the surrender period expires, you can usually withdraw money without penalty, though you may still owe income tax on the gains.

Tax treatment of annuities

How an annuity is taxed depends on where the money came from. If you bought an annuity with after-tax money (money you already paid income tax on), only the earnings portion of each payment is taxable. If you bought it with pre-tax money from an IRA or 401(k), the entire payment is taxable as ordinary income.

Annuities held inside a retirement account (like an IRA) grow tax-deferred, meaning you do not pay tax on the gains until you withdraw. Annuities held outside a retirement account are taxed on their earnings each year, even if you do not withdraw the money. This tax treatment can significantly affect how much you keep after taxes, so it is worth understanding before you buy.

When people use annuities and common alternatives

Annuities are most useful for people who have a large sum of money and want to convert it into may provide income they cannot outlive. Retirees often use them to cover essential expenses like housing and food, while keeping other money in investments for growth or flexibility. People who receive a lump-sum pension payout sometimes use annuities to recreate the monthly pension check they would have received.

Alternatives to annuities include living off investment returns from a diversified portfolio, taking withdrawals from a brokerage account, or relying on Social Security and part-time work. Some people use a combination: an annuity for essential expenses and investments for discretionary spending. The right choice depends on how much money you have, how long you expect to live, how much income you need, and how much flexibility you want.

Frequently Asked Questions

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

Most states require a free look-back period of 10 to 30 days after you buy an annuity, during which you can return it and get your money back. After that window closes, you can withdraw money, but you will owe surrender charges if you are still in the surrender period. Once the surrender period ends, you can withdraw without penalty, though you will owe income tax on any gains.

What happens to my annuity if the insurance company fails?

Each state has a guaranty association that protects annuity owners if an insurance company becomes insolvent. Coverage limits vary by state but typically range from $100,000 to $500,000 per person per company. This protection covers the payments owed to you, not the full value of your account. You can check your state's guaranty association website to learn the exact limits.

Is an annuity the same as a pension?

No. A pension is a benefit your employer provides and pays for. An annuity is a product you buy with your own money. However, when a company offers you a lump-sum pension payout, you can use that money to buy an annuity, which recreates the monthly income stream a traditional pension would have provided.

Can I buy an annuity inside a retirement account like an IRA?

Yes. You can purchase an annuity inside an IRA, 401(k), or other retirement account. The growth is tax-deferred, but you still pay the annuity's fees. Be aware that you cannot withdraw from the annuity without penalty until you reach the age specified in your retirement account rules, usually 59½.

What is the difference between an annuity and a life insurance policy?

Life insurance pays a lump sum to your beneficiaries when you die. An annuity pays you regular income while you are alive. Some products, called annuities with death benefits, do both — they pay you income during your lifetime and may provide a payout to your heirs if you die before the annuity is exhausted.