What Is an Annuity and How Does It Work?

ByAngelique Cruz
Edited byMegan Hull

Updated: October 27, 2023

ByAngelique Cruz
Edited byMegan Hull

Updated: October 27, 2023

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An annuity is a binding agreement between you and an insurance company where the insurer pays out invested funds, either on a monthly or one-time, lump-sum basis. Annuities benefit those nearing retirement and can be utilized as a regular source of income or a way to diversify your income portfolio. These investment vehicles can be an excellent tool to protect you from outliving your savings in retirement.

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Understanding How Annuities Work

Having a nest egg for your golden years is one thing; ensuring a steady income stream, even during retirement, is another. That’s where annuities come in. If you're seriously considering investing in an annuity, it’s essential to go beyond the definition of an annuity.

Annuities are popular among older, retired adults because they can serve to augment income streams. The end-to-end process of securing an annuity is relatively straightforward. After selecting an annuity type, you purchase a contract by making payments, either monthly or as a one-time, lump sum. Your insurer grows your money through investments and begins to issue payments back to you after a predetermined period.

1
Select the Type of Annuity You Want

Annuity contracts generally fall into three types — fixed, variable and indexed. Depending on your preferences, such as how much risk you're willing to take and whether or not you want guaranteed growth or your principal protected, one type might suit you better than another.

2
Start Making Payments

Purchasing an annuity entails making payments. You can do this in two ways, depending on your preference: give a lump sum payment or make several scheduled payments to your insurance company.

3
Give Your Money Time to Grow

Depending on the type of annuity you purchase and the stipulations of your contract, you may have to wait for a predetermined amount of time to pass before you begin to receive payments from your insurance provider.

4
Start Receiving Your Payments

Setting up your annuity contract involves several decision points. More than selecting a type and how you want to make payments, you can also choose how (and when) you receive payments. Some individuals may prefer receiving payments shortly after paying a lump sum; others choose a specific age when they want their insurer to begin payouts.

Annuity Phases

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Deferred and Immediate Annuities

If you want to spend smartly during retirement, it's crucial to understand how you receive income. We've already touched on the payout or annuitization phase, but let's break that down further.

Annuity contracts come in two types regarding payouts — immediate and deferred. This distinction doesn't refer to whether you’ll receive a lump sum or monthly payments, but when you’ll begin receiving payments.

As its name implies, an immediate payout means you’ll start getting payments within a year of purchasing your annuity (it may even be as short as a month after). Typically, this payout type is possible when you make a lump sum contribution. A deferred payout means you begin receiving funds at a future date, which may work in your favor since it allows your contract to earn interest and grow in value over time.

Taxes on Annuities

One benefit of investing in annuities is that they allow you to grow your savings on a tax-deferred basis. That means that your money is not subject to tax while your contract is in its accumulation phase. However, once your annuity enters the annuitization phase, your payouts are subject to income tax.

Types of Annuities

More than simply knowing the definition of an annuity, it's also crucial to understand the types of annuities you can purchase. Your choice affects several factors, including how insurance companies set your interest rates, how they invest your money and what amount of risk you’ll take on.

Types of Annuities
Type of Annuity
Description

Fixed Annuities

After purchasing your contract through a lump sum or a series of payments, a fixed annuity guarantees a return based on a fixed interest rate for a specified period. Once this period ends, your insurer can set another interest rate that may be higher, lower or identical to your original interest rate.

Fixed annuities work best for people who have a low tolerance for risk. Your insurance company typically invests in safer vehicles, such as highly rated corporate bonds or Treasury securities. Although it might now have as much growth opportunity as variable annuities, it is not affected by the ups and downs of the market.

Variable Annuities

While fixed annuities guarantee a steady but often low return, variable annuities may yield more growth by taking advantage of rising markets. With a variable annuity, your insurer offers a menu of investment options, and you have a say in which subaccounts your money goes. These may include stocks, bonds and money market instruments.

The value of a variable annuity contract depends on how much you contributed and the performance of underlying investments — that's where the risk lies. You might experience losses if the market dips, making variable annuities better suited for experienced investors who can tolerate more financial risk.

Indexed

An indexed annuity is the most complex among the different annuities available. While the yield of a variable annuity depends on the performance of investment options, an indexed annuity depends on a stock market index, such as the S&P 500. Note that the insurer doesn't invest your money in the index but uses its performance to calculate your return. So if the index has a gain, your contract value also increases. While indexed annuities are subject to market downturns, they usually offer some protection against risk.

Benefits and Drawbacks of Annuities

Purchasing an annuity is an investment. While an annuity can help you achieve your financial goals in your golden years, it also involves some risks. Understanding the benefits and drawbacks of annuities is a must, especially if you are seriously considering using them as a potential income stream.

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Fees Associated with Annuities

Purchasing an annuity can come with many advantages, the primary being an additional income stream when you retire. However, you must first put money into your annuity to earn these gains. Annuities can be expensive, not only because you have to come up with a principal but because they may also involve fees, much like other financial products. The more complicated your annuity is, the more fees you'll likely encounter.

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Alternatives to Annuities

Annuities are most popular with people preparing for retirement for several reasons: they allow you to grow your money tax-deferred, and once payouts begin, you receive regular payments, allowing you to manage your finances. Other retirement savings plans, such as a 401k or a Roth IRA, provide similar benefits, but an annuity can act as a supplement once you've maxed out these other financial vehicles.

However, it's essential to know that are other financial products available for consideration. We looked at two specifically — mutual funds and dividend stocks.

Mutual Funds

A mutual fund pools funds from several investors and puts them into securities. There are several types of mutual funds, such as money market, bond, stock and target date funds. You purchase shares representing your part ownership of the funds and dictate the income these funds generate.

Mutual funds share similarities with variable annuities in that your earnings for both depend on the performance of the investments in your portfolio. However, the former tend to provide a higher rate of return since annuities have additional costs due to the built-in guarantees they provide, like payouts and death benefits.

The tax treatment between the two is different, too. Annuities are tax-deferred during the accumulation phase, but withdrawals are subject to regular tax rates. If mutual funds are in a taxable account like an individual brokerage account or a joint account, they can create taxable income. After mutual funds produce capital gains or pay dividends, that income must be included on your tax return and reported to the IRS.

Dividend Stocks

If you invest in a company's shares, you'll receive income from that company’s earnings in the form of dividends. Typically, investors receive these dividends quarterly in the form of cash or reinvestment in additional stock. The company's Board of Directors determines the dividend payments and amounts.

Variable annuities and dividends share several similarities. For example, they both invest in the stock market and offer growth potential. However, some differences may help you decide which is better when you retire.

The advantage of choosing an annuity is you're guaranteed an income stream for life, assuming you get the life option for a fixed annuity. Other, riskier annuities — like variable and indexed annuities — typically offer a cap on losses. On the other hand, dividends can result in significant losses if the market drops because they’re dependent on stock performance. Owning stocks also comes with advantages. You're free to sell them for cash whenever you need funds. Annuities typically have a surrender period, where you cannot withdraw your money without incurring a penalty.

Annuities FAQ

Before investing in an annuity, it’s crucial to fully understand how they work and what types of annuities are available. If you're considering an annuity as an option for your retirement, here are some questions that may provide more information.

What are annuities, and why are they popular with those nearing retirement?
What are the different types of annuities available?
Can you customize your annuity contract?
Are there risks associated with purchasing annuities?
What is the tax treatment for annuities?
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Related Content

Knowing what an annuity is and how it works can help you determine whether it's the best financial product for you when you retire. However, retirement in and of itself is a broad subject, and more information is available online that may help. Here are some pages you may want to peruse:

  • Planning for Financial Success and Happiness: Your financial needs change at different stages in your life. Find some helpful tools for retirement and senior living, such as the Retirement Expenses Calculator on this page.
  • The 401(k): Retirement Fund Basics: MoneyGeek sheds more light on this employer-sponsored retirement savings option and how it works. You can get more information about joining one and making contributions.
  • Roth IRA: Not all retirement savings accounts involve an employer — some you can set up yourself, such as a Roth IRA. Our page covers the essentials, from opening one to contribution limits to making withdrawals.
  • Annuities vs. Life Insurance: What’s the Difference and What Should You Get? An annuity can provide a death benefit, but so does a life insurance policy. Explore how these financial products differ and see which suits your needs better.
  • How to Start Saving and Investing: Saving and investing can help you build a nest egg for your golden years. MoneyGeeks shares tried and tested ways to establish a financially secure future.

About Angelique Cruz


Angelique Cruz headshot

Angelique Cruz has been researching personal finance for three years, with expertise in macroeconomics, financial statistics and behavioral finance. After a decade-long stint as a management consultant creating professional and personal development programs, she now specializes in writing informative content around personal, auto and home loans. Angelique has a degree in psychology from the Ateneo de Manila University.


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