An annuity is an insurance contract.
You generally put money into a contract issued by an insurance company. Depending on the contract, the annuity may provide a way to accumulate value, convert value into an income stream, add optional income or death-benefit features, or pursue a combination of those objectives.
Annuities are not all structured the same way. The way value grows, the amount of market exposure, access to money, fees, surrender provisions, income options and guarantees can differ materially from one product to another.
Any guarantee is subject to the terms of the contract and the claims-paying ability of the issuing insurance company.
Accumulation and income are not the same thing.
Some annuities are primarily evaluated for how money can accumulate before retirement. Others are selected because of the way the contract can create income. Many contracts include elements of both.
During an accumulation period, value may earn fixed interest, index-linked interest, or investment-based returns depending on the annuity type.
An annuity may provide contractual methods for receiving income, including options that can continue for a specified period or, when provided by the contract, for life.
What are the major types of annuities?
What is the difference between an immediate and deferred annuity?
An immediate annuity is generally designed to begin income relatively soon after the premium is paid. A deferred annuity generally allows time before income begins and may be used for accumulation, future income planning, or both.
How can annuity income work?
Annuities can offer different ways to receive money. One traditional method is annuitization, which converts contract value into a stream of payments according to a selected payout option. Some contracts also offer optional or built-in withdrawal features designed to support income without traditional annuitization.
Income guarantees and withdrawal benefits vary by contract. A guaranteed income feature does not necessarily mean the contract's account value itself is guaranteed to grow or remain available in the same manner.
How are annuities taxed?
For a nonqualified annuity funded with after-tax money, earnings generally grow tax-deferred while they remain inside the contract. Tax-deferred does not mean tax-free. The taxation of withdrawals and income depends on the contract, how it was funded, the distribution method and applicable tax law.
Withdrawals may be subject to income tax and, in some circumstances, additional federal tax penalties. Annuities held inside tax-qualified retirement arrangements have different considerations because those accounts may already receive tax-deferred treatment. Consult a qualified tax professional for advice about your circumstances.
What tradeoffs should you understand?
An annuity can provide contractual benefits, but those benefits come with terms and limitations that should be understood before purchasing.
Many annuities have surrender periods or limits on penalty-free withdrawals. Taking more than the contract permits can result in surrender charges or adjustments.
Some annuities have explicit contract, investment or rider charges. Others incorporate economics through crediting terms or other contract provisions rather than a separately stated annual fee.
Read the actual contract terms. Liquidity provisions, surrender charges, market-value adjustments where applicable, crediting rules, rider costs, income provisions and guarantees can materially affect how an annuity performs for a particular objective.
Are annuities protected from market losses?
That depends on the annuity. A fixed annuity and the index-crediting component of many fixed indexed annuities can include contractual protections from direct market losses, subject to the insurer's contract and claims-paying ability. However, withdrawals, surrender charges, adjustments and other contract provisions can still affect value.
Variable annuities expose contract value to market risk. RILAs or buffered annuities can also expose the owner to downside loss according to the contract's buffer, floor or other loss-sharing structure.
Common misconceptions
Questions worth asking before buying an annuity
- What financial objective am I trying to solve: accumulation, income, protection, or a combination?
- What type of annuity is this, and how does its value change?
- How long is the surrender period, and how much can I access without a surrender charge?
- What fees, rider charges, spreads, caps, participation rates or other contract provisions apply?
- If returns are index-linked, exactly how is interest calculated?
- What guarantees are contractual, and which features can change?
- How would income be calculated if I use the contract for retirement income?
- What happens to the contract if I die?
- What are the tax consequences of withdrawals or income?
- How does this contract fit with Social Security, pensions, investments, cash reserves and my other retirement resources?
The bottom line
An annuity is an insurance contract that can serve several different retirement-planning purposes. The word “annuity” alone does not tell you whether a contract is conservative or market-exposed, liquid or restrictive, simple or complex, or appropriate for your situation.
Start with the financial objective, then evaluate the specific contract's accumulation method, income features, liquidity, costs, risks and guarantees.