What Is an Annuity?

By Chris Gavrel, Licensed Agent · 4 min read

Annuities can be a helpful retirement tool, and a confusing one. Here’s a plain-talk look at what an annuity is, the main types, and what to understand before you buy.

The basic idea

An annuity is a contract between you and an insurance company. You give the company money, either in one lump sum or a series of payments, and in return the company agrees to do one or both of these things:

Grow your money on a tax-deferred basis according to the contract terms
Pay you income, either starting soon or at a later date, for a set period or for life

Many people think of an annuity as a way to create their own “paycheck” in retirement, or as a place to keep money they don’t want exposed to market losses.

Two phases

Accumulation phase: Your money is growing. You may be able to take limited withdrawals.
Income (payout) phase: You turn the annuity into a stream of payments. This is sometimes called “annuitizing.”

The main types

Type	How it generally works
Fixed annuity	Credits a declared interest rate for a set period.
Multi-Year Guaranteed Annuity (MYGA)	A fixed annuity that locks in a rate for several years.
Fixed indexed annuity	Credits interest based partly on a market index, with limits such as caps, and protection from index losses.
Immediate annuity (SPIA)	Turns a lump sum into income that starts soon after purchase.
Variable annuity	Money is invested in subaccounts and can lose value. Sold only by securities-licensed professionals.

I work with fixed annuities, fixed indexed annuities, MYGAs, and SPIAs. I don’t offer variable annuities. You can read more in Fixed vs. Fixed Indexed Annuity and What Is a MYGA and SPIA?

Why people use annuities

To create guaranteed lifetime income options, depending on the option chosen, the contract terms, and the claims-paying ability of the issuing company
To protect part of their savings from market losses
For tax-deferred growth
To leave money to beneficiaries, often outside of probate

What to understand before buying

Surrender charges: Most annuities have a surrender period. Taking out more than the free-withdrawal amount during that time can trigger a charge. See What Charges Could You Face When Withdrawing Money?
Taxes: Earnings are generally taxed as ordinary income when withdrawn. Withdrawals before age 59½ may face an additional 10% federal tax (IRS Publication 575: Pension and Annuity Income).
Liquidity: An annuity is meant for long-term money. Keep enough cash available for emergencies.
Guarantees: Annuity guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company. Annuities are not bank deposits and are not FDIC insured.
Fees for riders: Optional features, like income riders, may carry annual charges.

Is an annuity suitable for you?

An annuity isn’t right for everyone. Before recommending one, a licensed agent is expected to look at your whole picture: your age, income, other savings, how soon you might need the money, your tax situation, and your goals. If you might need the money in the next few years, an annuity with a long surrender period probably isn’t a good fit.

Questions to ask

How long is the surrender period, and what are the charges each year?
How much can I withdraw each year without a charge?
What is guaranteed, and what isn’t?
Are there fees for any riders?
What happens to the money if I pass away?
How long is the free-look period in my state?

For more independent background, the SEC’s investor site has a helpful overview (Investor.gov (SEC): Annuities).

A simple example of how people use them

Here’s a made-up example. Picture a retiree with Social Security and some savings. Her monthly bills run a little more than her Social Security check. She keeps an emergency fund in the bank and uses part of her savings to buy an annuity that pays monthly income for life. Between Social Security and the annuity, her basic bills are covered, and the rest of her savings is still there for other needs. This is only an illustration. The right approach depends on each person’s situation.

What an annuity is not

It’s not a bank account or CD, and it’s not FDIC insured
It’s not meant for money you may need in the short term
It’s not a replacement for an emergency fund

Look before you sign

Every annuity comes with a contract and, in many states, a buyer’s guide and disclosure document. Read them, ask questions about anything unclear, and use the free-look period to review the contract once it arrives. A good agent will welcome your questions and never rush you.

If you’re wondering whether an annuity fits your retirement plan, I’m glad to explain your options plainly. As a licensed agent, I can compare products from several insurance companies. There’s never any obligation.

Sources

This article is for general educational purposes only and is not legal, tax, or financial advice. Coverage, pricing, and availability vary by age, health, state, and carrier.