An annuity is a contract between you and an insurance company that guarantees a stream of income, often for life, in return for a lump-sum payment or a series of payments over time. You only have to pay taxes on an annuity when you withdraw funds, and many people use annuities to protect themselves from the risk of outliving their savings.
Annuities can be a vital part of your investment strategy or retirement plan, but there are many types of annuities to choose from, as well as many different subtypes.
Annuities can be fixed, variable, or indexed depending on how you choose to invest your funds.
If you want to start receiving payments right away, you can opt for an immediate annuity. If you’d rather start withdrawing money in the future, you can buy a deferred annuity instead.
If you want to use pre-tax dollars to fund your contract — for example, with savings from a 401(k) plan or an IRA — you can buy a qualified annuity. If you use after-tax dollars, your annuity will be non-qualified.
The right type of annuity for you will depend on your age, your retirement plans, and your level of tolerance with investment risk.
Fixed vs. variable vs. indexed annuities
When you buy an annuity, your funds can grow at a fixed or variable interest rate. Fixed annuities offer guaranteed but modest returns, while variable annuities have the potential of higher returns — but the returns aren’t guaranteed, and you might lose money. Indexed annuities have elements of both.
Fixed annuities
Fixed annuities guarantee a steady source of income thanks to a predetermined rate of return. Your fund grows modestly, but your chances of losing money during a market downturn are zero. Often compared to certificates of deposit (CDs) for their simplicity and reliability, fixed annuities can be a great option if you’re risk-averse — but your annuity payments may lose value against inflation over time.
Variable annuities
Variable annuities, on the other hand, let you invest in the market by choosing index funds. 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.
At the same time, unlike fixed annuities, 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 — in other words, you may see bigger gains, but you may also lose money if the market underperforms. [1]
Indexed annuities
Indexed annuities are a hybrid between fixed and variable annuities. In an indexed annuity, your returns are based on the performance of a selected market index, such as the S&P 500. But instead of investing directly in the market, you’re using the index as a reference to determine the growth rate of your money. Indexed annuities usually come with caps that dictate how much you can earn, as well as floors that help you prevent losses.
Indexed annuities can offer the potential of higher returns compared to fixed annuities, without the risks of losing money associated with variable annuities. At the same time, the dollar amount of the income payments you receive may change depending on the performance of the reference index. If you have a moderate tolerance for risk, indexed annuities might be a good fit for you.
You can add riders to both variable and indexed annuities in order to mitigate their loss risks and guarantee a source of income for life, but these features come with fees that, combined with administration fees, can significantly reduce the amount of money you receive from your annuity payments.
Immediate vs. deferred annuities
The other big distinction between types of annuities relates to how soon you want to start receiving annuity payments after purchasing your contract. 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.
Immediate annuities
Immediate annuities start providing payments right away — or no longer than a year after the purchase of your contract. If you’re already in retirement and want to start receiving a steady stream of income, similar to a salary, as soon as possible, an immediate annuity might be a good fit for you.
Because you start receiving payments as soon as you buy your contract, immediate annuities are usually funded by a single lump-sum premium payment. This type of contract is usually called a single-premium immediate annuity (SPIA).
Deferred annuities
Deferred annuities delay the start of your payment schedule into the future — usually between five and 10 years, or longer. During this time, which is called the accumulation period, the money you contribute grows on a tax-deferred basis depending on the type of annuity investment you choose — fixed, variable, or indexed.
Once the accumulation period ends, you have the option to annuitize your contract, which means you can start receiving regular annuity payments based on a schedule of your choice — for a set period of time, for a set amount of money, or for the rest of your life. The shorter the period of time during which you receive payments, the larger each payment will be.
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.
Qualified vs. non-qualified annuities
Annuities are also classified by how they’re funded and the types of accounts in which they’re held. They can be qualified if you use pre-tax dollars and tax-advantaged accounts, or non-qualified if you use after-tax dollars and standard individual accounts.
Qualified annuities
Qualified annuities can be funded with pre-tax dollars and held in employer-sponsored retirement plans, such as a 401(k), 403(b), or 457(b). They can also be held as an individual retirement annuity (IRA).
Qualified annuities have contribution limits imposed by the IRS, because they’re usually held in tax-advantaged retirement accounts, like a 401(k) plan. These limits place a cap on the amount of money you can contribute to your annuity every year.
For 2024, the maximum annual contribution you can make to an IRA is $7,000 if you're under age 50. If you’re 50 years old or older, you can contribute $8,000.
If your annuity is held in a 401(k) plan, the maximum annual contribution you can make every year is $23,000 if you’re under age 50, or $30,500 if you’re age 50 or older.
Non-qualified annuities
Non-qualified annuities are funded with after-tax dollars. For example, you can buy a non-qualified annuity with savings, the sale of a large asset, or even funds from a windfall, like an inheritance or the proceedings of a lottery win.
If you own a non-qualified annuity, you aren’t subject to the annual IRS contribution limits. You can contribute as much as you want according to your insurer’s guidelines.
When you start receiving payments from a non-qualified annuity, only the portion of those payments that are considered earnings are taxed at ordinary income rates. If you decide to withdraw money from the principal, you won’t have to pay any additional taxes on it. [2]
What’s the best type of annuity for you?
The best type of annuity for you will be one that fits your financial needs, budget, and risk tolerance. There are no one-size-fits-all solutions when it comes to annuity contracts.
Annuities can complement your investment strategy and retirement plan by guaranteeing a stream of income for the rest of your life, but they’re highly customizable and complex financial products that aren’t always easy to understand. An expert financial advisor can help you find the right type of annuity for your particular situation.
What questions should you ask before you buy an annuity?
If you’re considering buying an annuity, make sure to have a clear understanding of the pros, cons, and features of your contract. Asking these questions before you speak to an insurance agent or financial advisor can help.
Are you planning to use your annuity to save for retirement or for a similar long-term investment goal?
Are you investing in the annuity through a retirement plan or IRA?
Have you already maximized your contributions to other tax-advantaged retirement accounts, like a 401(k) or IRA?
Do you need to start receiving a stream of income payments from the annuity now, or in the future?
Will you need to access the funds from your annuity in case of an emergency within the first few years of your contract?
Are you willing to take the risk that your account value may decrease in the case of a market downturn, in exchange for greater return potential? Or do you prefer an annuity that offers lower return potential in exchange for guaranteed payments?
Do you understand all the fees, commissions, and potential penalties your annuity may charge?
What’s the minimum guaranteed return on your annuity?
What death benefit options does the annuity offer?
Is the insurance company you’re buying the annuity from financially sound?
