Annuities explained: Basics, types & FAQs

An annuity is a contract between you and an insurance company to cover specific goals. Annuities are designed to be both a savings vehicle and a source of retirement income. After making either a lump-sum payment or ongoing payments, annuities can guarantee income for a set period of time (such as 25 years) or for the rest of your life. Annuity income payouts are usually monthly but can be paid at other intervals, such as yearly.

There are two primary stages to any annuity contract: the accumulation stage and the distribution stage.

The accumulation stage is the period that provides the opportunity to increase the value of your annuity over time. Any earnings from your annuity accumulate tax-free until you start making withdrawals. The benefit of tax deferral allows any earnings to grow faster because they aren't taxed yearly—your money compounds because taxes are not reducing it. Over time, the funds that would have otherwise gone to taxes may accumulate into a larger sum of money at the end of the accumulation stage. Most annuities have accumulation periods. But immediate annuities do not.

The accumulation period may last anywhere from a few years to decades depending on your needs and preferences.

The accumulation stage ends at the onset of the distribution stage. This is when you're ready to begin withdrawing funds to create an income in retirement. You can pick a length of time for payouts to last to fit your needs. It may be just a few years, or you can have payouts that are guaranteed to last for your lifetime.

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Annuities come in many shapes and sizes. The four basic types of annuities are immediate, deferred, variable and fixed. The types are primarily based on two factors:

• When you plan to begin payouts. You can either receive your annuity payouts immediately after paying the insurer a lump sum (immediate payments), or you can receive monthly payouts in the future (deferred payments).

• How your investment may potentially grow. Contributions to an annuity can grow in a couple of different ways—through interest rates (fixed return) or by investing your contributions in the market (variable return).

Immediate annuities provide a retirement income stream that starts right away, so they don’t have an accumulation period. You usually pay your insurer a one-time amount, then you begin receiving payouts in as early as 30 days. You may pick your payout schedule, such as monthly, quarterly or annually. A potential drawback of immediate annuities is that you're trading liquidity for guaranteed income. You generally won't have access to that full lump sum if you need it.

Immediate annuities are best suited for:

• People nearing retirement who want to begin receiving payments right away.
• Retirees who want another source of guaranteed income.

Deferred annuities provide a retirement income stream that you may start at a future date of your choosing. Before then, the money may be subject to a charge if taken out within a surrender charge period. Any interest or investment growth is tax-deferred until you make a withdrawal or begin receiving the payouts. It's this tax-advantaged aspect that makes a deferred annuity such a useful retirement tool.

A deferred annuity makes the most sense when:

• You are looking for retirement income later in life.
• You want tax-deferred growth potential.

Fixed annuities are a tool that can provide you with a guaranteed minimum interest rate and payout options later in life. There are several types of fixed annuities, each with certain characteristics that set them apart, but they share some basic traits. A main trait is their purpose—to provide features where you cannot lose money in the market.

Traditional fixed rate annuities earn interest at a guaranteed minimum interest rate for the life of the contract.

• These may be best for people whose top priorities are a guaranteed minimum interest rate and a reliable source of retirement income.

MYGAs earn interest at a guaranteed rate for a specified period, typically three to nine years.

• MYGAs may be best for people who want a guaranteed interest rate for a specified period of time.

Interest from a fixed indexed annuity depends on the performance of a specified index. If the index has positive returns, you may earn more interest than you would with a fixed rate annuity. If the index experiences negative returns, you won't receive interest, but your annuity will not be at risk of loss.

• Fixed indexed annuities may be best for people who want the opportunity to earn a higher interest rate with protection from market losses—and people who don't require the security of a guaranteed interest rate.
  

A variable annuity is a type of tax-deferred annuity contract that allows you to invest your money into subaccounts. Subaccounts can help an annuity's growth keep up with (and potentially outpace) inflation. Similar to mutual funds, subaccounts are dependent upon market risk and performance. Higher gains could offer higher payouts, while lower gains—or losses—mean smaller payouts.

Variable annuities may be a good choice if:

• You're comfortable with taking on more risk for a higher expected return.
• You have a long-term time horizon that may help you recover from market downturns.
• You've already maxed out your Roth IRA or 401(k) contributions for the year.

Annuities offer distinct benefits that can significantly improve your retirement plan. There are different types of annuities, and the specific features and advantages you receive depend on what you purchase. Some may be better for specific situations, but in general, the main reasons to buy one include:

• Guaranteed income options. Annuities are one of the few ways to receive a lifetime income stream. Social Security benefits and pensions (if you have one) often fall short of providing enough money for retirement. Your income from other savings may not be guaranteed, and it can be tough to predict how long your savings will need to last. Longevity risk—the issue of living longer than you'd planned—is something many retirees worry about. Annuities can provide guaranteed payouts for the rest of your life, reducing the risk of running out of money.

• The potential for growth. Some annuities are relatively low-risk, guaranteeing a steady growth rate—often around 1% to 2%. Other annuities are higher-risk, with funds tied to market performance and the gains and losses that come with it. You can choose the type of annuity that works best for you and use it to supplement more aggressive investments you might have in your retirement accounts.

• Additional tax deferral. Because annuities are tax-deferred, your money can grow without being reduced by taxes along the way, much like a 401(k) plan at work. You only owe tax when you receive payouts or take withdrawals from your contract.

In addition to growth potential and guaranteed income, annuities also provide specific tax benefits:

• The growth within an annuity is tax-deferred. Taxes on earnings or interest aren't due until you begin receiving payouts (usually, after you retire).

• Annuities can be funded with before- or after-tax money. Before-tax money is money typically from a traditional IRA or 401(k) rollover. With before-tax money, you pay income taxes on your total withdrawal. After-tax money may be from your savings account, an inheritance, a work bonus or a Roth IRA. With after-tax money, you only pay taxes on growth.
  

Before deciding on an annuity, you should also consider the potential cons.

• There are costs and potential penalties. Be sure to get a rundown on charges that apply to the product. Some annuities charge fees for annual maintenance and operations. Variable annuities also have charges that will vary based on the subaccounts you choose. If you take out funds early, you also may have to pay surrender charges.
  

• Withdrawals from annuities, including partial withdrawals and surrenders, may be taxable. If you make a withdrawal before age 59½, you may have to pay a 10% federal tax penalty in addition to your normal income tax.
  
• They may not keep up with inflation. During high inflationary periods, the cost of living can rise, and the growth of some annuities may not keep up with the inflation rate. Some types of annuities, like variable annuities, may be better equipped to keep up with inflation over the long-term, as you can select from several types of variable subaccounts.
  

Annuities can often be a great addition to a retirement plan. Common circumstances when it makes sense to consider an annuity include:

• You're nearing (or already at) retirement age and have a limited  pension or none at all. Do you have retirement money sitting in accounts without guarantees? It may be worth moving it to an annuity.

• You need to shrink your required minimum distributions (RMDs) from your IRA accounts. Already retired? At least one type of annuity may help you postpone required minimum distributions until a later age. A qualified longevity annuity contract (QLAC) is designed to help meet IRS requirements.

• You want to delay Social Security income. Annuities may provide an income stream that allows you to delay when you claim your Social Security benefit.

• You've maxed out your 401(k). Annuities are a retirement planning product. Consider them as you look for other places to make retirement contributions.

Insurers often require a minimum initial contribution to open an annuity. This may be an amount like $5,000 or $10,000. However, it will vary by insurer and contract. Also pay attention to maximum contribution limits. As with other tax-deferred products, annuities sometimes have contribution limits set by the IRS. Each type of annuity has its own requirements, so consult with a financial advisor for details.

Yes, you can lose money in an annuity. First, understand the risk based on the type of annuity you have. Here are some ways this could happen:

• Variable annuities are tied to market investments, which involve risk. Your value could fall if those investments do poorly. Don't choose a variable annuity as part of your retirement plan if you are averse to this type of risk.

• The insurer may be unable to pay its obligations when you retire. You can reduce this risk by choosing an organization with a strong rating. Look at reports from institutions such as AM Best, Fitch, Moody's or Standard & Poor's.

• Fees, expenses and penalties can impact the amount of money in an annuity. Early withdrawals (before age 59½), for example, can result in a 10% federal tax penalty on the amount of the gain withdrawn in addition to your normal income tax. Withdrawals before the contract’s specified time period may result in a surrender charge paid to your financial institution, too. Always read your prospectus and contract documents to learn what's true for your contract.

• Understanding your contract. Know what will or will not trigger penalties.

• Buying an annuity that is appropriate for you. For example, if you have a short time horizon or low risk tolerance, a variable annuity may not be right for you.

• Not investing too much of your money in an illiquid annuity. Ensure you have an adequate emergency fund or other savings you can access if you need to, so you don’t incur early withdrawal penalties or surrender charges.

Yes, an annuity is an asset. It's something of value that’s available to meet commitments or debts. However, the time when your annuity will be available to meet commitments or debts varies with the type of annuity you have. This means that an annuity (especially a deferred annuity) might not be a liquid asset. Usually, the decision to buy an annuity means trading access (liquidity) now for an income stream later on.

It's a good idea to consult with a tax professional for advice specific to your situation.

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It can be tough to predict how long your retirement savings need to last. Will you live to age 75? Or to age 105? The right type of annuity can help.

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When you pass away, you may be able to leave a benefit to your loved ones. Whether you have already started receiving payments or not will impact the type of benefits you may be able to leave.

• If you pass away during the accumulation period, the contract’s death benefit will be payable to your named beneficiaries. Your beneficiaries will receive at least the amount you contributed minus any withdrawals.

• If you die after starting annuity payouts, a death benefit, if any, will depend on the payout agreement. For example, if your payout agreement is for your life only, there will be no death benefit after you pass away. If your payout is for your life and your spouse’s life, the payouts will continue to go to your spouse after your death. Another option is if you have a life income with a guaranteed period. If you die within the guaranteed period, a death benefit will be payable to your named beneficiaries.

If you're in poor health and have a shortened life expectancy, or annuities don't align with your overall financial strategy or goals, then they may not be a good choice. For example, if you're saving to start a business when you turn 40 years old, annuities probably don't make sense.

There are other scenarios where annuities may not be the best option. For example, at an advanced age like 90, the value of a lifetime income source is significantly diminished for most people. On the flip side, at a younger age like 18, it may be a better financial move to focus on maxing out an employer-sponsored 401(k) match.

Consider enlisting the help of a financial advisor or broker. They can help sort through annuity products on the market. Consider your age, savings, single/joint status, life expectancy, state of residence, retirement finances and risk tolerance to find an appropriate annuity for you.

Generally speaking, annuities can be a great way to ensure you have enough funds to get through retirement. You might use them to complement other sources of income like Social Security. But before buying an annuity, consider whether you have enough liquid assets to cover health care, long-term care and other expenses and taxes.

1. Do you need retirement income now or later? People who need retirement income now should start by looking at an immediate annuity. For retirement income later, start with a deferred annuity.

2. Then ask, how much risk are you comfortable with? Do you want to play it safe and have a guaranteed stream of retirement income? Or do you want to take a financial risk in exchange for potentially higher rewards? If you have a lower risk tolerance, start by looking at a fixed annuity. If your risk tolerance is higher, think about a variable annuity.

3. Combine answers 1 and 2. By doing this, you'll know what type of annuity is the best fit for you—immediate or deferred and fixed or variable.

4. Talk with your spouse or family. If you want to include the people who are affected by your decision, now may be a good time.

5. Comparison-shop and pick an annuity. Shopping around can help you see differences in annuity fees and expenses. Enlist the help of a financial advisor if you could use guidance understanding the options.

6. Put a yearly retirement checkup on the calendar. Make a retirement review part of your year-end financial checkup. Reevaluate if you're on track for retirement.