How do annuities work?

Annuities can be a useful financial tool to manage your money, especially if your goal is to create an income after you stop working. Understanding how annuities work can help you create the best financial plan for your retirement years.

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Tory CrowleyAssociate Editor & Licensed Life Insurance AgentTory Crowley is an associate life insurance and annuities editor and a licensed insurance agent at Policygenius. Previously, she worked directly with clients at Policygenius, advising nearly 3,000 of them on life insurance options. She has also worked at the Daily News and various nonprofit organizations.

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Antonio Ruiz-CamachoAntonio Ruiz-CamachoAssociate Content DirectorAntonio helps lead our life insurance and disability insurance editorial team at Policygenius. Previously, he was a senior director of content at Bankrate and CreditCards.com, as well as a principal writer covering personal finance at CNET.

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What is an annuity?

An annuity is a contract between you and an insurance company. You’ll purchase the annuity with premiums, and in exchange the insurer will pay you an income. You can set up your annuity to pay you a certain amount, for a period of time, or for the rest of your life. 

You won’t have to pay any taxes on your annuity until you withdraw funds. Many people use annuities to protect themselves from the risk of outliving their savings during retirement. 

How does an annuity work?

First you’ll buy an annuity contract from an insurer making a lump-sum payment or a series of payments over time. The insurance company will then pay you an income from that annuity, often for the rest of your life. 

Within this structure, there are many ways to customize your contract, including how you’ll pay for it, how it’ll grow, how the money will be disbursed, and how it’ll be taxed. 

Who are the participants in an annuity?

  • Owner. The owner purchases the annuity. They pay for the contract and have the right to surrender it. They also choose the annuity’s beneficiaries. 

  • Annuitant. The annuitant is the person who receives the payments from an annuity. The annuitant and the owner can be different people, but often they're the same person.

  • Beneficiary. If your contract has a death benefit and the annuitant dies, any money left over will go to the beneficiary.

How do annuity premium payments work?

Premiums are the payments you make to buy an annuity contract. These payments are also what fund your annuity. When the insurer starts paying you an income from your annuity, the pay you receive back will be based on the premiums you paid into it, plus any growth. 

You can pay for an annuity with one lump-sum payment or several premium payments. 

Learn more about single premium vs. flexible premium annuities

How does an annuity’s accumulation period work?

The accumulation period is the time between when you fund your annuity and when you start being paid by it. During this time, your money will grow at a rate set by your contract. Annuities are tax-deferred, so you won’t pay any taxes during this time. 

Can annuities be used as a collateral for a loan?

How does an annuity’s annuitization period work?

Once the accumulation period is over, you start receiving income payments. This is called annuitization. With an income annuity, the annuitization or payout phase can last for a set number of years or the rest of your life.

If your annuity pays you for a set number of years and then ends, it’s called a fixed-period annuity. [1] If you die before the period ends, the balance usually goes to your loved ones as a death benefit. You can also set up a lifetime annuity, which pays you for the rest of your life.

Learn more about annuitization

How is an annuity taxed?

You can pay for an annuity with pre-tax or post-tax dollars. If you purchase an annuity with pre-tax dollars, it’s called a qualified annuity. With a qualified annuity, you won’t pay taxes until you withdraw money from your contract. At that time, the money you withdraw will be taxed as income. Qualified annuities are usually held in employer-sponsored retirement accounts, like a 401(k) plan, or individual retirement accounts (IRAs).

If you pay for an annuity contract with post-tax dollars, it’s called a non-qualified annuity. With a non-qualified annuity, you won’t have to pay taxes on the principal when you withdraw money. You’ll only have to pay taxes on any growth that’s accumulated, which will be taxed as income. Non-qualified annuities can be funded with savings, the sale of a large asset, a financial windfall, or any other funds at your disposal that have already been taxed.

What fees do annuities charge?

Annuities typically have small administrative fees that are built into your payment structure. Administrative fees are often less than 1% of the value of your annuity. 

You’ll also face surrender fees if you need to withdraw money from your annuity ahead of the agreed-upon pay schedule. These fees are charged so the insurer can cover the cost of creating the annuity and paying the commission fees.

Annuity contracts usually have a surrender period during which you have to pay surrender fees for early withdrawals — and it typically lasts seven years. During this time, the earlier you make a withdrawal, the higher the surrender fee you have to pay. For example, you may have to pay, say, a 5% surrender fee for taking out money from your annuity in the second or third year, but only a 2% fee if you withdraw money in the fourth or fifth year. 

What riders can an annuity include?

Riders are add-ons to your contract that can offer you additional benefits. But to offset the cost of a rider, insurance companies usually charge additional fees, which can reduce the amount of the payments you receive.

One of the most common riders to add to your annuity is a cost of living adjustment rider (COLA), which “ensures that your income won’t be eaten away by unexpected inflation in the future,” says Jeremy Eppley, certified financial planner at Silverstone Financial

Another common rider is the return of premium rider, which guarantees that if you die before your annuity pays you back all the money from the principal, any remaining balance will be paid to your beneficiaries.

What are the different types of annuities?

Annuities are characterized by both how they grow and when they pay out. Your annuity can grow at a fixed, indexed, or variable rate, each of which offers increasingly higher growth potential.

The other big distinction between types of annuities relates to how soon you’ll receive payments. You can choose an immediate annuity if you want to start receiving payments as soon as possible, or a deferred annuity if you want to wait a few years or more.

Learn more about the different types of annuities

Fixed

Fixed annuities guarantee a steady source of income thanks to a predetermined rate of return. Your funds will grow modestly, but your chances of losing money during a market downturn are zero. Fixed annuities are a great option if you’re risk-averse — but the low rate of growth may mean your annuity payments may lose value against inflation over time.

Indexed

Indexed annuities have increased growth potential compared to fixed annuities, but also increased risk. In an indexed annuity, your returns are based on the performance of a selected market index, such as the S&P 500. Indexed annuities usually come with participation rates and caps that dictate how much you can earn, as well as floors that help protect you from losses. If you have a moderate tolerance for risk, indexed annuities might be a good fit for you.

Variable

Variable annuities offer both the greatest growth potential and the highest risk by letting you invest in the market — you get to choose specific index funds, bonds, or stocks. If you like taking a hands-on approach to your investments and you’re familiar with how the market works, variable annuities give you more options than fixed annuities.

Keep in mind that variable annuities don’t offer guaranteed returns or any guarantees on your principal investment, and the amount of the payments you receive will depend largely on market conditions. This means that you may see bigger gains, but you can also lose money if the market underperforms. 

Learn more about fixed vs. variable annuities

Immediate

Immediate annuities are characterized by a quick turnaround between when you purchase your annuity and when it starts paying you. Immediate annuities pay you immediately — or technically, within 12 months —after you purchase them. If you’re already in retirement and ready to start receiving a steady stream of income, an immediate annuity might be a good fit for you.

Deferred

Deferred annuities delay the start of your payment schedule into the future — usually between five and 10 years, or longer, but always at least 12 months. During this time, the money you contribute grows on a tax-deferred basis depending on the type of annuity investment you choose — fixed, variable, or indexed. 

If you still have time to let your money grow before you need to receive a steady stream of income, a deferred annuity could be a good fit for you.

Learn more about immediate vs. deferred annuities

How do annuities help you save money?

Annuities are most effective as a means to manage your money, but they can also save you money by limiting your taxable income. You can purchase an annuity with pre-tax or post-tax income. Regardless, you’ll only pay taxes once. 

To minimize the amount of money you’ll pay in taxes, you’ll want to pay taxes when you qualify for a lower tax bracket. Ideally, if you expect to have a lower income during retirement — as most people do — a qualified annuity will be helpful to you. If you expect to have a higher income during retirement, a non-qualified annuity will be a more optimal fit. 

How do annuities help you prepare for retirement?

One of the most common uses for annuities is to create a reliable source of income during your retirement years. Setting up an annuity can give you peace of mind, knowing that the money you’ve saved will be allocated to funding your retirement years. 

You can also use annuities in tandem with retirement accounts, such as an IRA or 401(k) plan. Once your money is saved in a retirement account, you can put it in an annuity to provide for your retirement. 

Learn more about annuities vs. IRAs

Are annuities a good investment?

Annuities are generally optimized for reliability, rather than growth. However, you can use an annuity for investment purposes, and if growing your annuity funds is important to you, you can opt for a variable annuity, which has the largest potential for growth.

Are annuities a good investment?

How do you choose the best annuity for you?

Choosing the best annuity for you will come down to your unique financial needs and circumstances, including your age, investment goals, and risk tolerance. 

Your age

How close you are to retirement will impact which type of annuity will likely be best for you. If you’re 65 or older, an immediate annuity will likely be a better fit for you, as it’ll create an income stream you can use right away. Younger individuals may benefit more from a deferred annuity, which will allow your money to grow for a longer period of time before it starts paying you. 

Your investment goals

Deciding between a fixed, indexed, and variable annuity will largely depend on how aggressively you want to invest your money. Comparatively, a fixed annuity will offer low growth and low risk, an indexed annuity can offer moderate growth and moderate risk, and variable annuities will offer high growth potential and higher risk. 

Your risk tolerance 

Similarly, your risk tolerance will dictate if you should set up a fixed, indexed, or variable annuity. If you’re more comfortable with risk, you can choose which stocks your annuity will grow with. You’ll have the most potential for growth, but also risk potential loss. If you’re more uncomfortable with risk, you can choose a fixed annuity, which only offers a low rate of growth, but carries minimal risk and will prevent any loss. 

If you’re unsure which type of annuity will work best for you, speak with a financial advisor who can offer you unbiased advice.

Explore other annuity options

References

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  1. Insurance Information Institute

    . "

    What are the different types of annuities?

    ." Accessed June 03, 2024.

Author

Tory Crowley is an associate life insurance and annuities editor and a licensed insurance agent at Policygenius. Previously, she worked directly with clients at Policygenius, advising nearly 3,000 of them on life insurance options. She has also worked at the Daily News and various nonprofit organizations.

Editor

Antonio helps lead our life insurance and disability insurance editorial team at Policygenius. Previously, he was a senior director of content at Bankrate and CreditCards.com, as well as a principal writer covering personal finance at CNET.

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