How Annuities Work
An annuity is a contract you buy from an insurance company. It has up to two phases:
- The accumulation phase, when your money is in the contract earning interest under its terms. This is the stage for a deferred annuity.
- The income (payout) phase, when you turn the value into a stream of payments, for a set number of years or for the rest of your life. Choosing payments is called annuitization; an immediate annuity starts this phase soon after you buy.
The person who owns the contract is the owner; the person whose life the payments may depend on is the annuitant; and the beneficiary receives any death benefit. The NAIC’s Buyer’s Guide for Deferred Annuities, written by state insurance regulators, is a useful companion, and insurers commonly give a copy at the time of sale.
The Main Types We Discuss
| Type | How interest or income works | Main trade-off |
|---|---|---|
| Fixed (deferred) annuity | The insurer declares an interest rate, often guaranteed for a set period, with a minimum guaranteed rate | Predictable, but rates may not keep pace with inflation |
| Fixed indexed annuity | Interest is linked to a market index, limited by a cap, participation rate or spread, with a floor (often 0%) | Potential for more interest than fixed, with limits; more moving parts |
| Immediate income annuity | A lump sum is converted into payments for a period or for life | Income certainty, but the money is generally no longer accessible |
Variable annuities, which invest in market subaccounts and can lose value, are securities regulated differently; they are not what we discuss on this page. We are licensed insurance agents, not investment advisers, and our annuities page explains what we do and do not do.
How Annuities Are Taxed
IRS Publication 575 covers annuity income. In general terms:
- Tax deferral. Interest earned inside a deferred annuity is generally not taxed until you take it out.
- Withdrawals. For a non-qualified annuity (bought with after-tax money), earnings come out as ordinary income. Your original contributions, the cost basis, are not taxed again.
- Income payments. When you annuitize a non-qualified annuity, each payment is split between a tax-free return of your investment and taxable earnings.
- Before 59½. Many distributions taken before age 59½ carry a 10% additional tax on the taxable portion, with some exceptions.
- Qualified money. An annuity held inside an IRA or employer plan follows that account’s rules, including required distributions.
Taxes vary with your situation, so check with your tax professional before you buy or withdraw.
Surrender Periods and Liquidity
Most deferred annuities have a surrender period, often several years, during which taking out more than a set free-withdrawal amount triggers a surrender charge. The charge typically starts higher and steps down each year until it reaches zero. Some contracts also apply a market value adjustment on early withdrawals.
The practical rule: only put money into an annuity that you will not need for the length of the surrender period, and keep a separate emergency fund. Many contracts waive charges in situations such as nursing home confinement or terminal illness; the waivers are listed in the contract.
Riders and Fees
Riders are optional features added to a contract, usually for a yearly fee. Common examples include guaranteed lifetime withdrawal benefits, which promise a level of income for life regardless of account value, and enhanced death benefits. Ask what each rider costs each year, how the fee is calculated, and whether you are likely to use it. A rider you never use is a cost with no benefit.
If you are weighing an annuity to cover a shortfall between Social Security and spending, the retirement income gap calculator helps size the gap first.
Consumer Protections
State insurance regulators oversee annuity sales. The NAIC’s model regulation on suitability in annuity transactions, adopted in many states, requires an agent to gather information about your finances and goals and to recommend an annuity that serves your interests, and it requires disclosures about the product and how the agent is paid. The Idaho Department of Insurance regulates insurance sales in Idaho.
Annuity contracts also include a free-look period after delivery, during which you can cancel for a refund. Its length is stated in the contract.
Questions to Ask Before You Buy
- What problem is this annuity solving: income for life, safe growth, or something else?
- How long is the surrender period, what are the charges each year, and how much can I withdraw without a charge?
- What is guaranteed in the contract, and what is only illustrated?
- For an indexed annuity: what is the cap or participation rate, how often can it change, and what is the minimum?
- What riders are included, what do they cost, and do I need them?
- What is the insurer’s financial strength?
- How will this affect my taxes, and does it fit with my other retirement accounts?
Annuities often sit alongside other planning. If you are also thinking about protecting your family, see our life insurance guide; for care costs later in life, our long-term care page.
Wondering what guaranteed income could look like?
We will start with your income gap in retirement, then compare annuity options from carriers we represent, with the surrender schedule and fees laid out plainly.
Request a free comparison Call 208-350-9933Frequently Asked Questions
What is an annuity?
An annuity is a contract with an insurance company. You pay a single sum or a series of payments, and in return the insurer agrees to credit interest under the contract’s terms and, if you choose, pay you income for a set period or for life. Guarantees depend on the financial strength of the insurer.
How are annuities taxed?
Earnings inside an annuity generally grow tax-deferred until you take money out. When you withdraw from or receive payments from a non-qualified annuity, the earnings portion is taxed as ordinary income, while the return of what you paid in is not. IRS Publication 575 explains the rules, including a 10% additional tax on many distributions taken before age 59½.
What is a surrender charge?
A surrender charge is a fee the insurer deducts if you withdraw more than the contract allows, or cancel it, during the surrender period, which often lasts several years and usually declines over time. Many contracts let you withdraw a portion each year without a charge. Check the schedule in the contract before you buy.
Can a fixed indexed annuity lose money?
Index-linked crediting cannot be negative in a typical fixed indexed annuity, because of its floor, but you can still end up with less than you put in if you surrender early and pay surrender charges, or if fees for optional riders are deducted. Read the guaranteed minimum values in the contract.
Can I change my mind after buying an annuity?
Annuity contracts generally include a free-look period after delivery, during which you can cancel and get a refund. The length is set by state law and the contract, and it is printed on the contract’s cover page or in its terms, so read the contract as soon as it arrives.
Related Guides
Coverage pages for this topic: Annuities. Other topics in the Learning Center: Medicare, Health Insurance (ACA), Life Insurance, Final Expense, Long-Term Care, Disability Insurance, Supplemental Health, Short-Term Medical, Travel Insurance.
Sources
- NAIC — Buyer’s Guide for Deferred Annuities
- NAIC — Annuity suitability standard (consumer overview)
- IRS — Publication 575, Pension and Annuity Income
This guide does not quote interest rates, caps or payout rates: they change often and differ by insurer and contract. Annuity guarantees are backed by the issuing insurer, and no rate shown in an illustration is a guarantee unless the contract says so. This guide is general education, not individual advice.