What Is an Annuity and How Does It Work?

Get the scoop on annuities and how they work—in plain English!

Laura Adams, MBA
6-minute read
Episode #186

The disappearance of workplace pensions and the volatility in our financial markets have put annuities in the spotlight as a potential solution for retirees. In this article I’ll cover the basics of annuities and the major pros and cons to consider before buying one.

What Is an Annuity and How Does It Work?

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In its simplest form, an annuity is an agreement in which you make one or multiple payments in exchange for receiving a set amount of income for a period of time. They’ve been around for a long time and are commonly used by conservative retirees who want to make sure that they’ll have a regular income for the rest of their lives. Even though annuities are a way to invest money, they’re actually an insurance contract and therefore are only sold by insurance companies.

How Do Annuities Work?

Money that’s held in an immediate or a deferred annuity can be invested in three basic ways and are either called fixed, variable, or indexed:

  • A fixed annuity pays out a fixed rate of return on your money. It’s a guaranteed, predictable income stream, no matter what’s going on in the financial markets.

  • A variable annuity pays out a variable rate of return on your money. The income stream usually has a minimum guaranteed amount, but can increase depending on the performance of the underlying investments that you select, such as stocks or mutual funds, for instance.

  • An indexed annuity pays out a rate of return on your money that’s tied to an economic index, such as the S&P 500. It’s considered a hybrid of the fixed and variable types because you receive a minimum guaranteed payment, but can also enjoy a higher return when there are gains in the broader market.

What Are the Different Kinds of Annuities?

In addition to annuities having different investment options, there are also a number of different kinds of annuities. Annuities are classified in a variety of ways and are segmented by features such as:

  • the way you pay premiums;

  • when you start receiving income;

  • the length time you receive income; and

  • tax status.

The variety of all the features and options can make understanding annuities a little challenging; but I’m going to make it easy. Let’s start with the two broadest annuity categories: immediate and deferred.

What Is an Immediate Annuity?

An immediate annuity provides income right away—or at least within a year after you buy it. You plunk down a big lump sum payment, which is also called a single premium, and start receiving an income stream from that money each month. For example, let’s say you receive a life insurance payment of one million dollars after taxes and you want to create a monthly income from investing that money in an annuity. At immediateannuities.com you can see what your monthly payment would be based on your age and gender. If you were a 40-year-old female, for instance, a one million dollar annuity would give you about $4,400 a month right now.

What Is a Deferred Annuity?

The other broad category of annuities is a deferred annuity, where you receive income at a future date. You make one or multiple contributions during the annuity’s “savings phase” and then receive income either as periodic payments or as a lump sum during the “distribution phase.” So it’s similar to a retirement account where you set aside money that you access in the future. In fact, you can own a deferred annuity inside of a retirement account, such as a traditional IRA, 401(k), or 403(b).

What Is a Qualified Annuity?

If you own an annuity inside of a retirement account it’s called a qualified annuity and it’s subject to traditional retirement account rules. You know the drill: You contribute pre-tax dollars which are subject to the annual limit set by the IRS (which is $5,000 for 2010). Not only can you deduct your contributions from your taxable income in most cases, but you also defer paying taxes on the annuity’s earnings each year. You pay taxes on the money when you make withdrawals after age 59½. With a qualified annuity you must begin taking distributions no later than age 70½.

What Is a Non-Qualified Annuity?

A deferred annuity acts a bit like a retirement account, even if you don’t own it inside of a retirement account.

Now let’s talk about the rules for either an immediate or a deferred annuity when you own it outside of a retirement account—that’s called a non-qualified annuity. With a non-qualified annuity you must contribute after-tax dollars. There are no annual contribution limits, so you can put in as much money as you like. Even though you pay taxes on your contributions to a non-qualified annuity up front, you defer paying taxes on their earnings until you take withdrawals after the age of 59½. And unlike a qualified annuity (that’s held inside of a retirement account), you don’t have to start taking distributions at any particular age.

How Are Annuities and Roth Accounts Different?

You may notice that these rules sound similar to a Roth account—but don’t mix up the two. A Roth is a tax-free retirement account with annual income and contribution limits. A non-qualified annuity is not tax-free—you must still pay tax on your earnings when you take distributions. A non-qualified annuity might be a good option if you’re able to max out all of your tax-advantaged retirement options, such as a workplace retirement plan and an IRA, and you still have money left over to sock away for retirement.

So what I’d like you to remember is that a deferred annuity acts a bit like a retirement account, even if you don’t own it inside of a retirement account. You enjoy tax-deferred growth until you take withdrawals after the age of 59½. Early withdrawals from any kind of annuity are generally subject to income tax plus a 10% penalty. Some annuities also charge an additional penalty, called a surrender charge, for taking an early withdrawal.

Pros of Investing in an Immediate Annuity

Here are eight benefits to investing a retirement nest egg in an immediate annuity:

  1. You receive the security and peace of mind of having a guaranteed monthly income for your entire life.

  2. You can’t lose a large nest egg if you (or an advisor) manage it poorly.

  3. You don’t have to pay a financial advisor to manage your money.

  4. You don’t have to know anything about investing or spend time watching the markets, reviewing account statements, or managing your nest egg in any way.

  5. You don’t have to worry about mismanaging your money if you develop poor health or dementia.

  6. You postpone paying taxes on your investment earnings until you receive income.

  7. There’s no annual limit to the amount you can contribute to a non-qualified annuity.

  8. You get protection from creditors because the most they can access is your monthly income (the lump sum amount belongs to the insurance company). 

Cons of Investing in an Immediate Annuity

Okay, now for the cons. Here are eight reasons why you might not want to invest in an immediate annuity:

  1. If you (or an advisor) manage a nest egg well, you could earn a higher return and have a lump sum to leave to your heirs if you invest in other ways.

  2. You lose flexibility when you trade a lump sum amount for an income stream.

  3. You may never break even on your investment if you don’t live long enough.

  4. Commissions paid to sales agents can be 6% or more of your contract price.

  5. Fees for contract options and administration increase your cost and lower your overall investment return.

  6. If you need access to your money, taking an early withdrawal is expensive.

  7. You lock in a low return if you purchase a fixed annuity when interest rates are low.

  8. Your income is dependent on the health of the company that sold you the annuity. Find out how to assess the strength of an insurance company at the Insurance Information Institute at iii.org. Also learn about what protection annuity holders have through the state Guaranty Association.

Get Financial Advice About Annuities

There’s a lot more to consider when it comes to annuities, such as taxes and estate planning. So I recommend that you consult with a qualified fee-only financial advisor about whether buying an annuity fits into your long-term financial strategy. At the bottom of this article you’ll find links to annuity calculators, videos, and more helpful resources.

Money Girl Audiobooks and E-book

I want to thank everyone who’s downloaded a Money Girl audiobook or e-book and encourage you to submit a review wherever you bought it! You can get the audiobooks—Money Girl’s Guide to Retirement Planning and 10 Steps to a Debt Free Life—at Audible.com or in the iTunes store. And if you prefer reading, 10 Steps to a Debt Free Life is also available as a Kindle e-book on Amazon.com..

More Resources:

What is An Annuity? (Video)

Questions to Ask Before You Buy an Annuity (Video)
Annuity Info from the SEC


Instant Annuity Calculator
Vanguard Annuity Calculator

National Association of Personal Financial Advisors

The National Organization of Life and Health Insurance Guaranty Associations (NOLHGA)

Image courtesy of Shutterstock

About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura's previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.