An income annuity is an insurance contract between you and an insurance company that guarantees a stream of income in return for a lump-sum payment or a series of payments over time.
This type of annuity is known for providing a steady, reliable income stream, similar to a retirement pension. You’ll know what to expect in terms of how your annuity will grow, and how much it’ll pay you when you start to collect an income from it.
An income annuity can help you complement your retirement portfolio and reduce the risk that you outlive your savings.
What is an income annuity?
An income annuity guarantees a stream of income for a specific period of time, a specific amount of money, or for the rest of your life. Because it’s similar to a retirement pension, many people use income annuities to fund their retirement years. It often supplements Social Security income and other sources of retirement funds.
Learn more about other types of annuities
How do income annuities work?
The money you contribute to an income annuity first grows at a rate set by the terms of your contract. The accumulated value on your contract is then used to provide you with a stream of income in the form of regular payments. You can receive these payments on a monthly, quarterly, or annual basis — and you can set up an income annuity to pay you for a set period of time, a specific amount, or for the rest of your life.
Premiums
These are the payments you make to fund your annuity. It’s more common to fund an income annuity with one payment — such as your retirement savings. This type of contract is usually called single premium income annuity (SPIA).
But you also have the option to purchase an annuity with several payments made over time.
Accumulation period
The accumulation period is the time between when you fund your annuity and when you start being paid by it. If you choose to buy an immediate income annuity, your income payments will begin right away, so your contract won’t have an accumulation period. Immediate annuities are usually funded with a single lump sum premium payment.
Learn more about immediate annuities
But if you buy a deferred income annuity (DIA), your contract does have an accumulation period and you’ll likely be able to contribute more money through multiple premium payments over time. During this time, your money will grow at a rate set by your contract.
Learn more about deferred annuities
Annuitization or payout phase
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.
Surrender period
The surrender period is a time frame when you’ll be penalized for withdrawing money beyond the limits set on your contract.
Many annuities will charge you a surrender fee if you withdraw more than 10% of the accumulated value of your contract per year during the surrender period.
Most surrender periods last for seven years, but they can be longer or shorter depending on the terms of your contract.
Surrender fees usually decrease over time — this means you’d pay a higher penalty for withdrawals in the first year of your contract than you would in the third or fifth year.
“The surrender period is usually tied to the commission schedule that the producer [who issues the annuity] receives,” says Laura K. Cook, certified financial planner at Flourish Financial Life Planning, LLC. “The longer the surrender, typically the larger the commission.”
Fees & penalties
If you need to withdraw funds from your annuity earlier than the agreed-upon schedule, you could face extra fees and penalties, especially if you do this during the surrender period.
As much as you can, it’s usually in your best interest to fulfill the terms of your annuity contract, as fees can be expensive.
Guarantees & riders
Not every income annuity comes with a guaranteed rate of growth. Fixed income annuities do offer you a guaranteed growth rate, but usually, the rate is relatively low.
Other contracts, like indexed or variable annuities, come with return rates that may be tied to the stock market. While their potential for growth can be higher than what fixed annuities offer, they could also grow more slowly — or even not grow at all, which means your funds could lose value during a market downturn.
Indexed and variable annuities can offer certain guarantees in the form of a floor feature, which can buffer against losses.
You can also add riders to your annuity. Riders are add-ons to your contract that can offer you additional benefits.
For example, you can add a cost of living adjustment rider (COLA) to your annuity, 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.
You can usually add a rider to your annuity contract for an extra fee. But in order to offset the cost of guarantees and riders, insurance companies usually charge additional fees, which, combined with administration fees, can significantly reduce the amount of your income payments.
A financial advisor can help you decide if adding a rider to your annuity contract is worth the cost.
Tax implications
Income annuities can be purchased with both pre-tax and after-tax funds. Either way, your money will only be taxed once.
If you purchase your annuity with pre-tax income, it’s considered a qualified annuity, and you’ll have to pay taxes on each payment you receive from the annuity — both on your principal and any growth. Qualified annuities are usually held in employer-sponsored accounts, like a 401(k) or 503(b) plan, but also in individual retirement annuities (IRA).
Also, because they’re tax-advantaged contracts, the IRS has imposed annual contribution limits to qualified annuities — $23,000 per year if you’re under age 50, or $30,500 if you’re 50 years old or older. [2] For an IRA, the limit is $7,500 per year if you’re over 50 years old and $6,500 if you’re younger. [3]
However, if you purchased the annuity with taxed dollars, it’s considered a non-qualified annuity. You won’t have to pay taxes on the principal you receive back, but you’ll pay income tax on any growth. [4]
Non-qualified annuities can be purchased with any after-tax funds, including savings, the sale of a large asset, or even money from a windfall. They don’t have contribution limits — you can invest in a non-qualified annuity as much as you want.
What are the different types of income annuities?
What is a fixed income annuity?
Fixed income annuities are simple annuity products where your principal grows at a fixed interest rate set by the insurance company. You’ll know exactly how much you’ll pay, how fast your money will grow, and what your payments will be.
While your rate of growth is guaranteed, you’ll give up the chance to have more aggressive growth through other types of annuities. But if you want to take a conservative approach to investing in retirement and are risk-averse, fixed income annuities can be a good fit for you.
What is an indexed income annuity?
An indexed income annuity is unique in how the funds grow. Instead of having a fixed rate of growth, your annuity will be tied to the performance of a market index — such as the S&P 500. When the market does well, your payments will increase and when the market goes poorly, your payments will decrease — but because you’re not investing directly in the market, you can’t lose any money if there’s an economic downturn.
What is a variable income annuity?
A variable income annuity is like an indexed income annuity except you’ll get to decide where your principal is invested. This can be a good option for you if you’re familiar with stocks, bonds, and mutual funds and willing to take more risk with the growth rate of your annuity — but unlike fixed and indexed annuities, your principal may lose value if the market underperforms.
What are the pros & cons of income annuities?
Income annuities offer different features that may or may not work to your advantage. If you know the pros and cons of income annuities, you can decide if setting one up can be helpful to you.
Pros
Risk protection. An income annuity will protect you against the risk of outliving your savings.
Reliable income stream. You’ll have a reliable income not subject to market fluctuations — especially if you choose a fixed income annuity.
Complements retirement plan. If you already have Social Security income and a retirement account like a 401(k), an income annuity can help diversify your retirement plan by adding a predictable source of income.
Cons
Lacks liquidity. It’s very difficult to deviate from your original agreement within an income annuity. If an emergency happens and you need to withdraw funds early, it’ll be time-consuming and expensive.
No inflation protection. The guaranteed income that comes with an income annuity won’t necessarily keep up with inflation, and your money could lose value over time. Some income annuities may allow you to add a cost of living adjustment (COLA) rider, which helps your contract buffer against inflation, but these types of add-ons usually come with a fee that could reduce the amount of your income payments. [5]
Surrender charges. If you surrender part of your annuity early, you’ll have to pay hefty fees, and you could end up losing money overall.
What should you consider before buying an income annuity?
Your age
Most people use income annuities to manage their retirement savings to create an income stream during retirement, so it’s common to consider an income annuity when you’re reaching your retirement age.
However, there’s no age limit for setting up an income annuity. If you come into a large sum of money through an inheritance or some other windfall, you can set up an income annuity to help manage the funds.
Your investment goals
Income annuities can be used to meet most of your investment goals. You can set up your annuity to grow at a low, guaranteed rate, or if you’re more risk-tolerant, you can set up your annuity to grow with the market, potentially gaining or losing more over time.
Your risk tolerance
Fixed and indexed income annuities offer low risk compared to other investment options. If you’re risk-averse and want to have a high degree of confidence about how your investments will grow, these types of annuities can be a good fit. But if you’re more open to risk and want your money to grow quickly, you’ll be better off investing in stocks or bonds — or a variable annuity.
Who should consider an income annuity?
Income annuities are typically best suited to people who are retired or nearing retirement. Using your retirement savings to set up an income annuity as you enter into retirement can help you create a reliable stream of income and help you enter into retirement with a level of financial stability.
