Annuities: the basic types and how they work

An annuity is a contract between a person and an insurance company. The buyer pays the insurer, in one lump sum or a series of payments, and in return the insurer agrees to make periodic income payments that start right away or at a later date. The forms differ widely, so the word alone says little about what a particular contract does.

What an annuity is for

The SEC's investor education site says people typically buy annuities to help manage their income in retirement. It lists three things an annuity can provide:

• Tax-deferred growth. No tax is due on interest or investment gains inside the contract until money is withdrawn or paid out.
• Income payments. Payments can last for a set period, for the owner's life, or for the lives of the owner and a spouse or partner.
• A death benefit. If the owner dies before payments begin, a named beneficiary generally receives at least the contract's current value.

Lifetime payments transfer to the insurer the risk of living longer than one's savings last. That protection has a price, which shows up in the contract's fees or terms.

Immediate and deferred annuities

Annuities are classified first by when payments begin.

With an immediate annuity, the buyer makes a single payment and income typically starts within a year. This is the simplest form: a lump sum exchanged for a stream of payments.

With a deferred annuity, money is paid in and left to accumulate for future income. The years of growth are called the accumulation phase. The period when income is paid is the payout phase.

When income begins, the owner usually chooses a payout form: payments for one life, payments that continue for a surviving spouse, or payments guaranteed for a minimum number of years. Forms that cover more generally pay a lower monthly amount. Converting a lump sum into lifetime payments often cannot be undone.

The four main deferred types

The SEC lists four main types of deferred annuity, in order of increasing risk to the owner.

Fixed and fixed indexed annuities are insurance products regulated by state insurance regulators. RILAs and variable annuities are also securities, registered with the SEC and sold with a prospectus.

What annuities cost

According to the SEC, fees reduce the value of an annuity however they are collected. Some are easy to see, and some are not.

• Surrender charges. Many contracts charge a fee for withdrawals made within a certain number of years after purchase. These charges generally decline over time.
• Base contract fees. Often a percentage of the contract's value. As a hypothetical illustration, a 1% annual fee on a $200,000 contract would be $2,000 a year.
• Underlying fund fees. In a variable annuity, the mutual fund options carry their own expenses on top of the contract fee.
• Optional benefit fees. Add-ons such as an enhanced death benefit or a guaranteed minimum income benefit typically cost extra.
• Implicit costs. Many fixed, fixed indexed and index-linked contracts charge no explicit ongoing fee. The cost is instead reflected in the interest rate the insurer credits or in caps on how much the contract can earn.

Taxes and early withdrawals

Withdrawing money from an annuity may be a taxable event. The SEC also notes that withdrawals before age 59½ may be subject to a 10% tax penalty on top of regular tax. The IRS explains how the taxable part of annuity payments is figured in Topic no. 410.

An annuity held inside a traditional IRA or 401(k) does not receive any additional tax deferral, because those accounts are already tax-deferred.

Risks and limits

An annuity's guarantees are promises of the insurance company. In the SEC's words, the insurer's obligations are subject to its financial strength and claims-paying ability. If the company runs into financial difficulty, it may be unable to pay.

A fixed payment also loses purchasing power as prices rise, which Investor.gov describes as inflation risk, unless the contract includes an inflation adjustment.

State law gives buyers a set number of days, usually 10 to 30 according to the SEC, to cancel a new annuity after receiving the contract. This is called the "free look" period, and the contract states how long it lasts.

Questions regulators suggest asking

The SEC's page lists questions for anyone considering an annuity. Among them:

• Which type is this, and how does its interest or investment performance work?
• What are all the fees, including surrender charges and any limits on gains?
• How long must the money stay in the contract to avoid charges, penalties and adjustments?
• What is the death benefit, and how is it calculated?
• How financially strong is the insurance company?

Exchanging an existing annuity for a new one deserves particular care. The SEC points out that the old contract may impose a surrender charge, the new one may start a fresh surrender period, and the person recommending the exchange may be paid for it. See how financial advisers are paid.

For how an annuity can fit alongside other income, see turning savings into retirement income. A related decision is covered in pension lump sum vs. monthly payments.