What is an annuity?

Reviewed by Ryan Hart
Licensed Insurance Agent

Have you ever wished there was a way to get guaranteed monthly payments for life after you retire? That's what an annuity does. It's a contract between you and an insurance company.

You pay money upfront, and the annuity company promises to pay you back later. An annuity provides a way to get steady income over time, often for retirement.

I think annuities can be helpful for people who love predictable monthly payments. They come in different types, so you can pick one that fits your needs. 

Some annuities start paying right away, while others wait until you're older. It's worth looking into if you're worried that Social Security won't be enough to cover your expenses in retirement.

Editor's Note: Annuities are more common than you might think. In fact, you may already be familiar with these types of annuities:

  • Pension: An annuity contract between you and your employer.
  • Lottery payout: An annuity contract between you and the state lottery fund.
  • Social Security: An annuity contract between you and the U.S. Social Security Administration.

How does an annuity work?

Before I can enjoy the benefits of an annuity, first I must give some money (called the "premium") to an insurance company. This money can be a lump sum or regular payments over time.

The insurance company then pays a set interest rate on my money each year. This is called the accumulation phase. My money grows tax-deferred during this time.

When I'm ready to start getting payments, I let the insurance company know. This is called annuitization.

The company calculates how much they'll pay me based on: 

  • How much money I put in 
  • How long the money grew 
  • My age 
  • How long I want payments to last

I can choose to get payments for a set number of years or for the rest of my life. Some annuities even continue payments to my spouse after I'm gone.

There are different types of annuities too. A qualified annuity uses pre-tax dollars, like a 401(k). Non-qualified annuities use after-tax money.

The key thing to remember is that annuities turn a chunk of money into steady income. It's like creating my own personal pension plan.

Types of annuities

Annuities come in a few basic varieties. Each type works a bit differently and offers its own mix of risks and potential rewards:

Fixed

Fixed annuities are pretty straightforward. I get a guaranteed interest rate and know exactly how much money I'll receive. The insurance company decides the rate, which usually stays the same for a set time.

These are great if I want stable, predictable returns. I don't have to worry about market ups and downs affecting my payments. 

One downside is that fixed rates might not keep up with inflation. But for many people, the safety and certainty make up for that.

Indexed

Indexed annuities are a bit more complex. They link my returns to a stock market index, like the S&P 500. I can potentially earn more than with a fixed annuity, but there's also more risk.

These annuities usually have a cap on how much I can gain. They also often have a floor, so I won't lose money if the market tanks. It's a middle ground between fixed and variable annuities.

I like that indexed annuities offer some protection against market drops. But they can be tricky to understand.

Variable

Variable annuities are the wild card of the bunch. My money goes into sub-accounts, which are like mutual funds. I can choose how to invest based on my risk tolerance and goals.

These annuities offer the highest growth potential. If the market does well, I could see big gains. But there's also a real chance of losing money if investments tank.

I think variable annuities are best for people who are okay with risk and want to actively manage their investments. They're not great for someone who needs steady, predictable income.

Annuity payout options

When it comes to annuities, there are two main payout options to choose from: deferred and immediate. Each has its own perks and suits different financial needs.

Deferred

With a deferred annuity, I can put off getting my money for a while. It's like saving for the future. I pay in now, and the cash grows tax-free until I'm ready to start taking it out.

This option is great if I'm still working and want to beef up my retirement savings. I can pick when I want to start getting payments, which gives me flexibility.

When I'm ready for income, I can take it as a lump sum or set up regular payments.

Immediate

If I need income right away, an immediate annuity is the way to go. I hand over a chunk of money, and the insurance company starts sending me regular payments almost right away.

This is perfect if I'm already retired or close to it. I don't have to worry about managing investments - I just get a steady stream of cash.

Some key points about immediate annuities:

  • Payments can be monthly, quarterly, or yearly
  • I can choose fixed or variable payments
  • Some offer inflation protection

The downside? Once I buy in, I usually can't change my mind or get my lump sum back.

Annuity benefits

I think annuities have some pretty cool perks. Let's break them down:

Guaranteed income: One of the best things about annuities is they can give me a steady paycheck for life. No matter how long I live, I'll keep getting money. That's pretty sweet!

Tax benefits: My money grows tax-free until I take it out. This means more cash in my pocket over time.

Savings protection: Fixed annuities keep my initial premium safe. I won't lose my hard-earned cash if the market takes a dive.

Death benefits: If I pass away, my loved ones can get the money I've saved. It's a nice way to leave something behind.

Here's a quick list of other perks:

  • Regular income stream
  • Lifetime income options
  • Protection against outliving my savings

Annuities can be a solid choice for seniors who want a stable income in retirement. They're not for everyone, but they're worth checking out.

I like that I can customize an annuity to fit my needs. Whether I want growth, income, or both, there's probably an option that works for me.

Remember, annuities can be complex. It's smart to chat with an annuity broker before jumping in.

Annuity risks

Before we wrap up, I want to tell you about some risks with annuities. They're not all sunshine and roses.

One big risk is surrender charges. If I need my money back early, I might have to pay a hefty fee. These charges can last for years after I buy the annuity.

Withdrawal penalties are another bummer. If I take out too much money before I'm supposed to, I could face some steep costs.

There's also inflation risk. What if the cost of living gets so high that my annuity payments no longer cover my monthly expenses? That's a scary thought.

It's important to read the fine print and understand what I'm getting into. I don't want any surprises down the road with my retirement savings.

Annuity FAQ

Annuities can be tricky to understand. I'll cover some frequently asked questions about how they work and compare them to other options.

What are the pros and cons of choosing an annuity?

Pros of annuities include guaranteed income for life and tax-deferred growth. I like that they can provide peace of mind in retirement.

Cons are limited upside and less flexibility with your money. You might get lower returns compared to other stock market investments.

How do you calculate the payout you might get from an annuity?

To estimate annuity payouts, I'd look at the amount invested, my age, and current annuity rates. The insurance company uses these factors to figure out payments.

Higher interest rates usually mean bigger payouts. My risk tolerance matters too - safer options pay less. I'd ask for quotes from different companies to compare.

How does an annuity compare to a 401k for retirement savings?

A 401k plan lets me choose which stocks I invest in and can have higher growth potential compared to bonds or CDs. I like that my employer might match contributions. But I could lose everything in a stock market crash.

Annuities offer guaranteed income but less control. They're taxed as ordinary income when I withdraw. But since they are insurance contracts and not investments, there is less risk that I will lose my life savings in the next recession or global pandemic.