Annuity (insurance product)

A contract with an insurance company in which a person pays money up front or over time in exchange for payments later, often for life.

What it means

An annuity turns savings into future income backed by an insurer. Immediate annuities begin paying soon after a lump-sum purchase; deferred annuities grow first and pay later. Fixed annuities credit a set rate, variable annuities rise and fall with underlying investments, and indexed annuities credit returns linked to a market index within caps and floors. The buyer gains guaranteed income; the insurer profits from fees, spreads and pooling longevity risk.

Guarantees depend on the insurer’s ability to pay, and state guaranty associations offer limited backup that varies by state. Earnings grow tax-deferred, but withdrawn earnings are taxed as ordinary income, not capital gains, and withdrawals before age 59½ can add a 10% IRS penalty on earnings. Surrender charges often apply for years if money is pulled out early.

Example

Suppose a retiree pays $100,000 for an immediate annuity quoted at $500 a month for life. That is $6,000 a year, so it takes about 16.7 years of payments to receive back the original premium.

How it’s used

Creating a pension-like income stream in retirement
Insuring against outliving savings
Tax-deferred saving after other retirement accounts are maxed out

Strengths and weaknesses

Strengths

Can provide guaranteed income for life
Tax-deferred growth on earnings
Shifts longevity and some market risk to the insurer

Weaknesses

Fees and surrender charges can be high, especially on variable and indexed products
Money is often locked up, reducing liquidity and flexibility
Earnings are taxed as ordinary income, and fixed payments may lose value to inflation

Good to know

Annuity contracts are complex; the surrender schedule, all fees and the insurer’s financial strength are worth reading before signing.

Educational information only, not financial, tax or legal advice. Rules, limits and rates change; check the IRS, your lender or plan, or a qualified professional before acting.