Annuities: A concise guide

What is an annuity?

An annuity is a contract sold by an insurance company that converts a lump sum or periodic premiums into a stream of payments. Those payments can begin immediately or at a future date and may continue for a fixed period or for the lifetime of the annuitant. Annuities are primarily used to provide steady retirement income and to hedge the risk of outliving savings.

Key points

• Annuities provide guaranteed or market-linked income in retirement.
• Two main phases: accumulation (funding) and payout (annuitization).
• Can be immediate or deferred; structured as fixed, variable, or indexed.
• Often illiquid and may include surrender periods and fees.
• Tax treatment depends on whether the annuity is qualified (pre-tax) or nonqualified (after-tax).

How annuities work

1. Accumulation phase: You fund the annuity with a lump sum or regular payments. Money grows tax-deferred.
2. Payout (annuitization) phase: The insurer begins periodic payments according to the contract terms—either immediately (immediate annuity) or after a specified deferral period (deferred annuity).

Regulation varies: variable and some indexed annuities are treated as securities (SEC/FINRA oversight) while fixed annuities are regulated by state insurance departments. Sellers typically need insurance licensing and, for variable products, securities credentials.

Types of annuities

By timing
* Immediate annuity: Starts payments right away after a lump-sum purchase.
* Deferred annuity: Payments begin at a future date chosen by the owner.

By return structure
* Fixed annuity: Pays a guaranteed interest rate and set periodic payments.
* Variable annuity: Payments vary with the performance of underlying investments; offers growth potential but carries market risk.
* Indexed annuity: Returns are linked to the performance of an index (e.g., S&P 500) and often include downside protection with capped upside.

By payout option
* Life-only: Payments continue until the annuitant dies (no refund of remaining principal).
* Period certain: Pays for a fixed term (e.g., 10 or 20 years), regardless of survivor status.
* Joint-and-survivor: Continues payments while either spouse is alive.

Common riders and features

Riders modify or enhance base annuity benefits, usually for extra fees:
* Guaranteed lifetime withdrawal benefit (GLWB) — protects minimum income even if investments fall.
* Death benefit — pays a beneficiary if the annuitant dies before receiving certain value.
* Cost-of-living/inflation riders — adjust payments for inflation.
* Acceleration riders — allow early access for terminal illness.

Costs and liquidity

• Surrender periods: Many annuities have multi-year surrender periods with charges for early withdrawals; common allowances include penalty-free withdrawals up to a modest annual percentage (often ~10%).
• Fees: Can include mortality and expense charges, administrative fees, investment management fees (for variable annuities), and rider fees.
• Complexity: Contracts vary widely; fees and return structures can be hard to compare.

Taxation basics

• Qualified annuity: Funded with pre-tax dollars (e.g., via a 401(k) or IRA). Withdrawals are taxed as ordinary income.
• Nonqualified annuity: Funded with after-tax dollars. Withdrawals are taxed on the earnings portion first; contributions are not taxed again.
• Tax deferral: Investment growth inside most annuities is tax-deferred until distributions are taken.
• Required minimum distributions (RMDs): Variable annuities held inside tax-deferred retirement accounts are subject to standard RMD rules.

Annuities vs. life insurance

• Annuities address longevity risk by providing income while the annuitant lives.
• Life insurance addresses mortality risk by paying a death benefit to beneficiaries.
• Cash value from permanent life policies can sometimes be exchanged for an annuity (e.g., via a 1035 exchange) without immediate tax consequences.

Use in workplace retirement plans

Employers can offer annuity options within 401(k) and 403(b) plans. Regulatory changes have made it easier for employers to add annuity providers, potentially increasing access to guaranteed income options within workplace plans.

Pros and cons

Pros
* Predictable, guaranteed income stream (depending on contract).
* Tax-deferred growth during accumulation.
* Longevity protection—can eliminate the risk of outliving savings.

Cons
* Illiquidity and surrender penalties.
* Potentially high and complex fees.
* Inflation can erode fixed payments if no inflation rider is purchased.
* Contract complexity makes comparison difficult.

Who should consider an annuity?

Annuities may suit individuals seeking reliable retirement income, with limited liquidity needs and a desire to hedge longevity risk. They are generally not appropriate for younger investors who need access to capital or for those seeking high liquidity.

Frequently asked questions

What is a nonqualified annuity?
* A nonqualified annuity is purchased with after-tax dollars; only earnings are taxed upon withdrawal.

Will I get my principal back?
* It depends on the contract. Life-only payouts typically stop at death (no principal refund). Period-certain or certain death-benefit riders may preserve some principal or transfer value to beneficiaries.

What is a surrender period?
* A surrender period is the length of time during which early withdrawals may incur a penalty. It commonly ranges from a few years to more than 10 years.

Bottom line

Annuities can convert savings into a predictable income stream and protect against outliving assets, but they come with trade-offs: limited liquidity, complex terms, and fees. Evaluate the specific contract features, costs, tax implications, and how the annuity fits your overall retirement plan before buying. Consider consulting a qualified financial professional to determine suitability.