What Is an Annuity? How Annuities Work

Search Fintrev

Search our guides, reviews and glossary.

An annuity is a contract with an insurance company. You pay a premium, either as one lump sum or as a series of payments, and in exchange the insurer promises to pay you income. That income can start right away or at a future date, and it can last for a set number of years or for the rest of your life. In general finance and accounting, “annuity” also means any series of equal payments made at regular intervals, such as loan installments or rent; the insurance product takes its name from that pattern.

Most people encounter annuities in retirement planning. Their main job is to convert savings into a paycheck you cannot outlive, which is a different goal from growing wealth as fast as possible.

Key takeaways

• An annuity is an insurance contract that trades a premium for a stream of payments, for a fixed period or for life.
• A deferred contract has an accumulation phase, when money grows tax-deferred, and a payout phase, when income comes out.
• Annuities are classified by timing (immediate or deferred) and by how returns are credited (fixed, variable or indexed).
• Surrender charges, fees and tax rules make early access expensive.
• Annuities address longevity risk (outliving your money). Life insurance addresses mortality risk (dying early).

How an Annuity Works

An annuity contract involves a few parties. The owner buys and controls the contract. The annuitant is the person whose life expectancy determines the payments, usually but not always the owner. The beneficiary receives any remaining value if the contract provides a death benefit. The issuer is the insurance company that guarantees the payments, so any guarantee depends on its ability to pay.

The money you pay in is called the premium. With a single-premium annuity you pay once. With a flexible-premium annuity you can add money over time, monthly or whenever the contract allows.

The Accumulation Phase

In a deferred annuity, the accumulation phase runs from the first premium until income begins. During this period, the account value grows according to the contract type: a declared interest rate for a fixed annuity, the performance of chosen investment subaccounts for a variable annuity, or a formula linked to a market index for an indexed annuity.

Growth inside the contract is tax-deferred. You owe no income tax on interest or gains until money comes out, so earnings compound on the full balance rather than an after-tax balance.

The Payout Phase

The payout phase begins when you start taking income. You can take withdrawals from the account value, or you can annuitize, which means converting the balance into a guaranteed stream of payments. Annuitizing is usually irreversible: the insurer now owes you payments, and you no longer have a lump sum to draw on freely.

Payments can be monthly, quarterly, semiannual or annual, depending on the contract and what you elect. Monthly is common because it mirrors a paycheck and matches regular living expenses.

Payout Options

How long payments last, and whether anything is left for heirs, depends on the payout option:

1. Life only (straight life): payments continue for as long as the annuitant lives and stop at death, with no refund of principal even after only a few payments. Because the insurer keeps any unpaid balance, this option generally produces the largest payment per dollar of premium.
2. Joint and survivor: payments continue as long as either the annuitant or a second person, usually a spouse, is alive. The survivor may receive the full amount or a reduced share.
3. Period certain: payments last for a fixed term, such as 20 years, regardless of how long the annuitant lives. If the annuitant dies early, the beneficiary receives the remaining payments.
4. Life with period certain or refund: lifetime income plus a guarantee that payments, or a return of principal, continue to a beneficiary if death occurs early.

Each guarantee for heirs reduces the income you receive, because the insurer is promising to pay more in total.

Immediate vs. Deferred Annuities

An immediate annuity (often called a single premium immediate annuity, or SPIA) is bought with one lump sum, and income begins within a year of purchase, often at the next payment interval. It suits someone who already has a large sum, such as retirement savings, a pension lump sum, a legal settlement or a lottery win, and wants to turn it into predictable cash flow.

A deferred annuity has an accumulation phase first. You choose a future date or age when income will start, and the money grows tax-deferred until then. A deferred income annuity is a variant where you lock in a future lifetime income amount today rather than building an account value you manage. A qualified longevity annuity contract (QLAC) is a deferred income annuity bought inside a retirement account under special IRS rules that let income start late in life.

Fixed, Variable and Indexed Annuities

• Fixed annuities pay a guaranteed interest rate during accumulation, with a guaranteed minimum, and fixed periodic payments in the payout phase. The insurer bears the investment risk.
• Variable annuities invest premiums in subaccounts, which work much like mutual funds holding stocks, bonds and other securities. Your account value and future payments rise and fall with those investments, and you can lose principal.
• Indexed annuities (also called fixed indexed annuities) credit interest based on a market index such as the S&P 500, usually with a floor that protects principal from index losses and caps or participation rates that limit how much of the gain you receive. They do not invest directly in the index.

The annuity fund is the pool of investments behind a variable contract: the portfolio in which your premiums are invested. Its returns drive the account value and, after annuitization, can drive the size of variable payments.

Riders

Riders are optional features added to the base contract, generally for an extra annual charge, though some contracts include certain riders at no cost. Common ones include:

• Guaranteed lifetime withdrawal benefit (GLWB): lets a variable or indexed annuity owner withdraw a set percentage each year for life, even if the account value falls to zero. This gives a variable contract market upside with a floor on income.
• Income riders: guarantee a specific future income level once you turn it on. Terms and rates depend on the deferral period, so the age at which you will need the income matters, as does the rider’s annual cost.
• Death benefit riders: guarantee beneficiaries a minimum amount, such as total premiums paid or a stepped-up value.
• Cost-of-living riders: increase payments each year in line with the consumer price index (CPI), at the price of a lower starting payment.
• Terminal or chronic illness riders: accelerate access to money if the annuitant is diagnosed with a qualifying condition.

The Annuity Formula

Whether you are pricing an insurance product or a car loan, the underlying math is the same: a level payment stream discounted or compounded at an interest rate. Two timing conventions matter:

• An ordinary annuity makes payments at the end of each period (most loans and bond coupons).
• An annuity due makes payments at the start of each period (rent, many insurance premiums).

Present value of an ordinary annuity:

PV = PMT × [1 − (1 + r)^−n] ÷ r

Future value of an ordinary annuity:

FV = PMT × [(1 + r)^n − 1] ÷ r

Here PMT is the payment per period, r is the interest rate per period, and n is the number of periods. For an annuity due, multiply either result by (1 + r), because every payment earns or is discounted for one extra period. The bracketed term in the PV formula is called the present value interest factor of an annuity, and annuity tables list it for common rates and terms.

Hypothetical example, present value: a stream of $10,000 a year for 20 years, discounted at 5% per year, paid at year-end.

• (1.05)^20 ≈ 2.6533, so (1.05)^−20 ≈ 0.3769
• Factor = (1 − 0.3769) ÷ 0.05 ≈ 12.462
• PV ≈ $10,000 × 12.462 = $124,622

If the same payments arrive at the start of each year (annuity due), PV ≈ $124,622 × 1.05 ≈ $130,853.

Hypothetical example, future value: saving $5,000 at the end of each year for 25 years at 5% annual growth.

• (1.05)^25 ≈ 3.3864
• Factor = (3.3864 − 1) ÷ 0.05 ≈ 47.73
• FV ≈ $5,000 × 47.73 ≈ $238,600

These formulas assume a constant rate and equal payments. Real insurance annuities add mortality assumptions, expenses and the insurer’s profit margin, so the formula explains the mechanics but will not reproduce a quote.

Example of an Annuity

Hypothetical example, period-certain payout: a 65-year-old pays a single $200,000 premium for an immediate annuity that pays monthly for 20 years. To see the mechanics, assume a 4% annual rate (0.3333% per month), 240 monthly payments, and no fees.

Rearranging the present value formula to solve for the payment:

PMT = PV × r ÷ [1 − (1 + r)^−n]

• (1.003333)^240 ≈ 2.2226, so (1.003333)^−240 ≈ 0.4499
• PMT ≈ $200,000 × 0.003333 ÷ 0.5501 ≈ $1,212 per month

Over 20 years that totals about $290,900, with the excess over $200,000 coming from interest earned on the declining balance.

A life-only version of the same purchase works differently. The insurer pools many annuitants: those who die early leave money in the pool that funds payments to those who live longer. This mortality pooling lets a life annuity pay more than a person could safely withdraw from their own savings. Actual payout rates depend on the buyer’s age and sex, interest rates at purchase and the insurer’s pricing.

A fixed payment also loses purchasing power. At a hypothetical 3% annual inflation rate, $1,212 received in year 20 buys roughly what $671 buys today (1,212 ÷ 1.03^20).

Taxes on Annuities

Tax treatment depends on how the annuity was funded.

A qualified annuity is held inside a tax-advantaged retirement plan such as a 401(k), 403(b) or IRA and funded with pre-tax dollars. Because neither contributions nor earnings have been taxed, withdrawals are generally taxed in full as ordinary income, and required minimum distribution rules apply.

A non-qualified annuity is bought with after-tax money outside a retirement plan. Your contributions are your cost basis, so only the earnings are taxable when withdrawn. For withdrawals before annuitization, the IRS treats earnings as coming out first. Once annuitized, each payment is split between a tax-free return of basis and taxable earnings using an exclusion ratio.

Two other rules apply broadly:

• Early withdrawals: taxable amounts withdrawn before age 59½ are generally subject to a 10% additional federal tax on top of ordinary income tax, unless an exception applies.
• 1035 exchanges: Section 1035 of the Internal Revenue Code allows you to exchange one annuity for another, or the cash value of a permanent life insurance policy for an annuity, without triggering tax in many cases. A new contract can restart a surrender period, so a tax-free exchange is not necessarily a cost-free one.

Annuity gains are taxed as ordinary income rather than at capital gains rates, which matters when comparing them with a taxable brokerage account.

Regulation and How Annuities Are Sold

Oversight depends on the product type:

• Fixed annuities are insurance products, not securities, and are regulated by state insurance commissioners.
• Variable annuities are securities. They are regulated by the Securities and Exchange Commission (SEC) and state insurance regulators, and FINRA oversees the firms and representatives who sell them.
• Indexed annuities are normally regulated by state insurance commissioners. If an indexed product is registered as a security (registered index-linked annuities), the SEC and FINRA also have jurisdiction.

Agents selling any annuity need a state life insurance license; selling variable annuities also requires a securities license. Sellers commonly earn a commission based on the contract’s value. That compensation is often built into the product’s charges, including surrender fees, rather than billed separately, which is one reason costs can be hard to see.

Annuities in Workplace Retirement Plans

Defined benefit pensions and Social Security already function as lifetime annuities, paying steady income until death, often with survivor benefits. People who will receive a substantial pension, or federal workers weighing the annuity options in the Thrift Savings Plan, may need less additional guaranteed income than people relying only on their savings.

Limitations of an Annuity

Surrender Charges and Liquidity

Most deferred annuities impose a surrender period, during which withdrawing more than an allowed amount triggers a surrender charge. Depending on the product, surrender periods run from about two years to more than ten. Charges can start at 10% or higher and typically decline each year until they reach zero. The charge functions as a deferred sales fee: it lets the insurer recover commissions and costs if you leave early.

Many contracts allow penalty-free withdrawals of up to 10% of the account value each year. Withdrawals beyond the free amount may be charged, and the tax rules above apply regardless of the contract’s schedule.

Hypothetical example: a $100,000 deferred annuity has a 7% surrender charge in year one that drops by one percentage point each year, plus a 10% annual free withdrawal. In year two you withdraw $20,000. The first $10,000 is free; the other $10,000 is charged 6%, or $600. If you are under 59½, the taxable portion may also face the 10% additional tax.

Owners who need cash after annuitizing sometimes sell future payments to a third-party buyer for a lump sum, usually at a steep discount to their total value.

Fees and Complexity

Variable annuities in particular can stack several charges: mortality and expense risk charges, administrative fees, subaccount fund expenses and rider fees. Indexed annuities use caps, spreads and participation rates that limit returns in ways that are hard to compare across products. Reading the contract and prospectus, and asking for every charge in writing, helps avoid signing without understanding how crediting, fees or penalties work.

Inflation and Opportunity Cost

Unless you buy a cost-of-living rider, fixed payments shrink in real terms every year. Money committed to an annuity is unavailable for other goals, and a lifetime payout leaves nothing to heirs unless you pay for a guarantee.

Insurer Risk

Guarantees are only as strong as the issuing insurer. State guaranty associations provide a backstop up to limits set by each state, but they are not the same as FDIC insurance on bank deposits.

Annuities vs. Life Insurance

Both are sold by insurance companies and both use actuarial pricing, but they protect against opposite risks.

Life insurance covers mortality risk, the risk of dying too soon. You pay premiums, and the insurer pays a death benefit to your beneficiaries when you die. The insurer loses money on policyholders who die early and relies on actuarial pricing so that, on average, premiums cover claims and profit.

Annuities cover longevity risk, the risk of living longer than your money lasts. The insurer’s risk is that annuitants live long enough to collect more than they paid in. Because the two risks offset each other, life insurers can use annuity sales as a natural hedge against their life insurance books.

Other Distinctions Readers Confuse

Annuity vs. IRA. An IRA is a tax-advantaged account type; an annuity is a product. You can hold an annuity inside an IRA (a qualified annuity), but the IRA already grows tax-deferred, so the reason to use one there is the income guarantee, not the tax treatment. An individual retirement annuity is a specific form of IRA set up as an annuity contract with an insurer.

Who Buys Annuities?

Annuities fit people who want stable, guaranteed income in retirement and will give up liquidity to get it. Typical buyers are near or in retirement, have savings beyond an emergency fund, and worry about outliving their money or managing withdrawals in volatile markets. Annuities are generally a poor fit for younger savers, anyone who may need the money soon, and anyone without a clear income goal. A large planned expense during the surrender period, such as a home purchase or a wedding, argues for keeping that money outside the contract.

Buying an annuity hoping to cash it out later at a profit misuses the product; its value lies in the guarantee of payments. Knowing your net worth, other income sources and expected expenses helps size how much, if any, of your savings to convert.

FAQs

The Bottom Line

Annuities suit people near or in retirement who have savings beyond an emergency fund and want guaranteed income they cannot outlive. In exchange for that income, buyers give up liquidity and often pay layered fees, and fixed payments lose value to inflation over time. Before signing, compare surrender schedules, rider costs and the insurer's strength, and keep money for near-term expenses outside the contract.