How annuities work: the basics

When you buy an annuity, typically from an insurance company, the provider invests the money with the goal of gaining value over time or generating interest, often while protecting your nest egg. Depending on the type of annuity, you can purchase it with a lump sum of money or contribute to the account over time. And with most annuities, once you buy, you enter the accumulation phase—you continue funding the annuity before payments to you begin.

When you start taking income from your annuity, you’re in the annuitization phase. The insurer will begin making regular payments to you. Depending on the kind of annuity you have, you’ll get income for either a set period or the rest of your life (like Social Security). This steady stream can help you budget and cover expenses in retirement.

Before you buy an annuity, it’s important to understand how it might affect your taxes. There are also events that can reduce the annuity’s value (and your eventual payments). For example, different annuities may have different rules for survivor benefits or for what happens if you withdraw money before the date you and the provider agreed upon. (That date will be in the annuity contract. Different annuities have different terms and conditions for withdrawals.)

Annuities with guarantees depend on the financial strength of the insurance company. If the company were to fail (however unlikely), you could lose money. So, consider that company’s history and track record—and read (and understand) the fine print—before you buy. To check the health of an annuity provider, review its financial strength rating from one of the leading insurance company analysts, Standard & Poor’s, Moody’s, or A.M. Best.

Types of annuities

Different kinds of annuities have different characteristics. When choosing, keep in mind your goals and needs.

Fixed vs. variable vs. indexed

Essentially, fixed annuities provide you with more certainty: You can be reasonably sure of your payments when the time comes. By contrast, variable annuities can generate higher gains but also involve more risk and uncertainty, especially when markets are volatile.

Deferred vs. immediate

Some retirees take money from their retirement accounts and use it to buy an immediate annuity. This way, they can begin getting the regular cash flow they need to cover essential expenses in retirement. (Retirees can also withdraw directly from a retirement plan as they need the money, but that income won’t be guaranteed.)

Are annuities taxable?

Yes, annuities are generally taxable, but only the portion of payments attributable to earnings is subject to tax in most cases. The key factor is whether the annuity is funded with pre‑tax or after‑tax dollars, which determines what portion of your payments is taxable.

Qualified vs. nonqualified

• You fund a qualified annuity with pre-tax dollars. For example, if you use money from a “traditional” 401(k) or IRA to buy or add to the annuity, it’s considered qualified. The earnings and interest from the annuity are tax-deferred, but withdrawals are taxable.
• A nonqualified annuity is funded with after-tax dollars. Because it’s money you’ve already paid taxes on, you only owe taxes on any gains the annuity accumulates.
• An annuity funded with after-tax Roth dollars—whether from an IRA or workplace retirement plan—also can grow tax-deferred, but withdrawals are tax-free if you meet certain criteria.

How are annuity payments taxed?

It depends on how you funded the annuity. Payments from a qualified annuity are fully taxable at your regular income rate, while payments from a nonqualified annuity are only taxed on the earnings portion.

Insurers use a formula called an “exclusion ratio” to determine how much of your payment is taxable. It compares the amount of pre-tax dollars used to buy the annuity with any earnings, along with your estimated life expectancy. If you live longer, your remaining payments may become fully taxable.

Note that some annuity providers let you withdraw a small portion of your annuity’s value without a charge. (Larger withdrawals or those you make before age 59½ could result in an additional 10% tax.) If you fund an annuity with money from a Roth account (after-tax investments with potentially tax-free withdrawals), your annuity payments could also be tax-free. Ask a knowledgeable tax professional to review your situation.

Are annuities a good investment?

Annuities can be a good investment if you need regular, predictable income to cover expenses during retirement. However, they're not right for everyone—the answer depends on your specific financial needs, retirement goals, and risk tolerance. It's essential to weigh the benefits of guaranteed income against the trade-offs, including fees, complexity, and reduced flexibility.

When do annuities make sense?

An annuity can make sense if you want the security of steady payments to cover your basic living expenses in retirement. You don't have to use your entire retirement account to purchase an annuity.

Instead, you can use some of it on an annuity that meets your basic income needs. Keep the rest in your 401(k) or other retirement account for future growth and to cover extras.

The lifetime income that annuities offer comes with trade-offs. Annuity contracts can be complicated, and they come with exclusions, limitations, benefit reductions, and fees.

It's important to run the numbers carefully. A trusted financial professional can help you learn the details and determine whether an annuity is a good choice for you.

How do annuities pay out?

Annuities pay out through regular income payments based on the payout option you choose, such as payments for life, for a fixed period, or with survivor benefits.

When do annuity payments begin?

Annuity payments begin either immediately after you purchase the annuity or at a future date you choose, typically when you retire. The timing depends on which type of annuity you select—immediate or deferred.

Common payout options

• Life only: Annuity payments continue as long as you live. This option typically provides the highest payment amount but ends when you pass away.
• Joint and survivor: Payments will continue to a spouse or other beneficiary after you pass away. This ensures your loved one maintains income even after your death.
• Fixed period: Your annuity payments will last for a set period, such as five, 10, or 20 years. If you pass away during this period, your beneficiary receives the remaining payments.

What happens to your annuity payments after you pass away?

It depends on the payout option you've selected. Most annuities include a standard death benefit that pays your beneficiaries either what you'd paid into the annuity (minus any withdrawals) or the annuity's current account value, whichever is greater.

This death benefit is generally built into an annuity at no extra cost. Some annuities offer enhanced death benefits, such as an extended payout period, for an extra fee.

What’s the difference between an annuity and a 401(k)?

A 401(k) is an employer-sponsored, tax-advantaged retirement savings plan where you invest in stocks, bonds, or mutual funds with market-based growth potential. An annuity is an insurance contract where you pay a lump sum or series of payments in exchange for guaranteed income streams, typically starting in retirement.

Both your workplace retirement plan and an annuity can be useful for your retirement future, but there are important differences between them. For example, 401(k)s are offered through employers (or organizations), though employees (or members) are responsible for funding their own accounts.

Other “defined contribution” (DC) plans include 403(b)s (available to some public school and hospital employees) and 457(b)s (government and nonprofit workers). 401(k)s and similar plans offer important tax advantages. In a traditional 401(k), you contribute pre-tax dollars, and the account can grow tax-deferred until you withdraw from it, typically in retirement. In a Roth 401(k), you invest after-tax dollars, but “qualified” withdrawals are tax-free later on. Another advantage: Some employers match a portion of what you put in your account to encourage you to save for your future.

Should you choose to save in an annuity instead of a 401(k)? Not necessarily. If your employer offers a 401(k) or similar plan and matches contributions, you should save at least enough there to take full advantage of the match.

Also note that you may—or may soon—be able to access annuities through your 401(k). The plans’ cousins, 403(b)s, have allowed many of their investments to be annuitized (guarantee regular income payments in retirement) for years. Now, thanks to the SECURE Act of 2019, it’s easier for 401(k)s to offer them too.

Another plus: 401(k)s and similar defined contribution plans are portable—you can take your account with you if you leave your job. (However, plan‑specific annuitization features generally only carry over to another employer plan that offers them, though an IRA can always be used to purchase an annuity separately.)

If you don’t have access to an employer‑sponsored retirement plan or are limited by IRA income rules, you may want to consider purchasing an annuity, either with a lump sum or through regular payments.