Annuity:
Definition, Types, Benefits & Comparison

An annuity is a contract between you and an insurance company that provides guaranteed income payments in exchange for a lump-sum payment or series of premium payments. The insurance company makes regular income payments to you, either for a specified period or for the rest of your life, typically used as a retirement income tool.

Annuities function as long-term retirement investment products that can offer guaranteed income, tax-deferred growth, protection from market volatility, and estate planning advantages. The contract shifts a portion of retirement risk away from you and onto the insurance company, which manages your money and provides the agreed-upon payments.

Related terms: premium, annuitant, deferred annuity, immediate annuity

Annuities fall into 2 broad categories based on when payments begin: immediate annuities and deferred annuities.

Immediate annuities are purchased with a single lump sum and begin paying out regular income within one year of purchase. You can choose from various income options, including some that provide income for your spouse or beneficiaries if you die prematurely.

Deferred annuities allow you to accumulate tax-deferred savings with the option to convert all or part of the annuity into an income stream either for a specific period or for as long as you live in retirement. There are 4 common types of deferred annuities:

• Fixed annuities offer a fixed rate of return guaranteed to never fall below a certain minimum rate
• Variable annuities offer growth potential from a choice of underlying investment options and provide a guaranteed death benefit for beneficiaries
• Structured annuities provide opportunities for growth and a level of protection that helps manage investment risk
• Fixed index annuities provide opportunities for growth based on the performance of certain market indexes while protecting your principal from losses

Deferred annuities operate through 2 distinct stages that separate the savings period from the payout period.

The accumulation phase occurs when you pay premiums into the annuity. Depending on the type of annuity, you can pay over a specified period, with one lump sum, or with add-on payments. During this period, your money grows tax-deferred.

The distribution phase begins when you start receiving payments. Depending on the terms of the annuity contract, you receive monthly, quarterly, or annual payments. This phase can last for a predetermined period or for the rest of your life.

With a deferred annuity, you pay the annuity company premiums over a specified period or in one lump sum, and then in the future, often many years later, the annuity company starts paying you.

Annuities offer 5 main payout options that determine how long payments continue and who receives them.

• Life payout: You receive payments until you pass away, but payments do not continue for your beneficiary
• Period certain payout: You receive payments for the period your contract specifies, and if you pass away before the end of the period, your designated beneficiary receives the payments until the contract period ends
• Joint-life payout: You receive a lifetime payout for yourself and one other person, typically a spouse, though the payout is typically lower because it covers two lives
• Life-with-period-certain payout: You receive payments for the rest of your life, but if you pass away during a specified period, your beneficiary receives payments only for the duration of that period
• Cash refund: Upon the passing of the last surviving annuitant, beneficiaries receive a refund of any difference between your original principal and the payments received

Annuities provide 4 key benefits that make them valuable retirement planning tools.

• Guaranteed income: Annuities can provide regular, guaranteed income for the rest of your life, for a set period, or provide a bridge to Social Security if you choose to retire early
• Tax advantages: The money inside an annuity grows tax-deferred, meaning any gains on the amount of premium invested are not taxed until the money is withdrawn
• Protection from market volatility: Some annuity contracts offer guaranteed rates of return that will never go below the guaranteed rate, offering protection from market volatility
• Estate planning advantages: Most annuities offer a death benefit that protects your original investment for your beneficiaries, and annuity contracts offer several options for survivor benefits

The timing for purchasing an annuity depends on your age, life expectancy, financial needs, and retirement goals.

Immediate annuities make more sense for those who have already retired or are close to doing so because they typically pay out right away. Deferred annuities may make sense if you have a longer time horizon, as your premiums will have more time to benefit from tax-deferred growth, and if you have already maxed out contributions to tax-advantaged retirement accounts like an IRA or 401(k).

Consider purchasing an annuity if you need additional retirement income beyond Social Security and pension plans, want to ensure you won't outlive your savings, or seek protection from market volatility during retirement.

An annuity's tax treatment depends on whether you purchase a qualified or non-qualified annuity.

Qualified annuities are purchased through a qualified retirement account, such as a traditional or Roth 401(k), which means your annuity is subject to the same tax rules that govern those accounts. You pay taxes on the entire distribution.

Non-qualified annuities are not purchased through a qualified retirement account and are funded with after-tax dollars. With non-qualified annuities, you only pay taxes on the earnings or interest portion of the distribution, not the principal.

Both qualified and non-qualified annuities are subject to a 10% IRS early withdrawal penalty if withdrawals are taken before age 59½. Withdrawals of taxable amounts from an annuity are subject to ordinary income tax.

Annuities carry several costs that can reduce your returns and should be carefully evaluated before purchase.

Annuities are typically sold on commission, which can amount to anywhere from 1% to 10% of the total value of the contract. Deferred annuities often include surrender charges, which are penalties for withdrawing funds before a specified surrender period ends. The surrender fee is typically a percentage of the withdrawal amount and usually declines over time.

Variable annuities may have additional fees for underlying investment options and optional riders or features. These costs can be higher than other retirement vehicles and can significantly reduce the owner's returns over time.

The difference lies in how you fund the annuity contract with the insurance company.

A single premium annuity requires you to make one lump-sum payment to the insurance company at the time of purchase. This payment immediately begins earning interest or gets invested according to the annuity type.

A multiple premium annuity allows you to make several premium payments to the insurance company over time. This structure lets you spread out your investment rather than committing a large sum upfront.

If you die before your income payments start, your beneficiary typically receives the value of your annuity, though the specific outcome depends on your contract terms.

Most annuities offer a death benefit that protects your original investment for your beneficiaries. Your beneficiary may want to cash in the annuity, but they should verify whether surrender charges apply. Some annuity contracts provide that beneficiaries will receive any difference between your original principal and the payments received, eliminating concerns that the insurance company will keep your money.

The tax treatment for beneficiaries varies depending on whether the annuity is qualified or non-qualified, and beneficiaries should consult with a tax advisor regarding their specific situation.

An annuity is often compared to 3 similar retirement products:

Annuity vs. Certificate of Deposit (CD)

Both annuities and CDs can offer fixed rates of return for a set period of time. CDs are FDIC-insured up to $250,000 per depositor and typically have shorter terms. Annuities are insurance products subject to the claims-paying ability of the issuing insurance company and typically have longer terms. While CDs offer more liquidity and principal protection through FDIC insurance, annuities offer tax-deferred growth and the option to convert to lifetime income.

Annuity vs. 401(k) or IRA

Both annuities and qualified retirement accounts like 401(k)s and IRAs offer tax-deferred growth. However, 401(k)s and IRAs have annual IRS contribution limits, while annuities do not. Annuities are typically purchased after you have maxed out contributions to qualified retirement plans. Unlike 401(k)s and IRAs, annuities can provide guaranteed lifetime income payments and are issued by insurance companies rather than being investment accounts.

Annuity vs. Pension Plan

Both annuities and pension plans can provide regular, guaranteed income for life. Pension plans are employer-funded retirement benefits that fewer companies offer today. Annuities are individually purchased contracts that you fund with your own money. Annuities can effectively replace pension income for workers who don't have access to traditional pension plans, offering similar pension-like cash flow during retirement.