What Is an Annuity? A Complete Guide to How Annuities Work

Annuity Meaning: The Basics

An annuity is a contract purchased from an insurance company. In exchange for your premium, the insurer agrees to make future payments back to you — either starting right away or at a later date you choose.

Annuity payments can be structured in several ways:

• Monthly, quarterly, or annual installments
• A single lump-sum payment
• Payments for a set number of years, or for the rest of your life

Fast Fact: Americans hold roughly $2.6 trillion in annuity reserves outside of retirement accounts, compared to an estimated $19.2 trillion held across all types of IRAs, according to Investment Company Institute data.

How Do Annuities Work? Tax-Deferred Growth Explained

Money invested in an annuity grows tax-deferred, meaning you don’t pay taxes on investment gains while the money stays in the contract.

Here’s how taxation works when you eventually withdraw funds:

• Your original contribution is not taxed again when withdrawn (you already paid tax on it before investing).
• Earnings are taxed as ordinary income when withdrawn.
• There is no annual contribution limit on annuities, unlike many retirement accounts.

Types of Annuities

There are three main types of annuities, each with a different approach to growth and risk.

Fixed Annuities

A fixed annuity offers a guaranteed payout — typically a set dollar amount or a set percentage of the funds in the annuity. This makes fixed annuities appealing to buyers who want predictable, stable income.

Variable Annuities

A variable annuity lets you allocate your premium across various investment subaccounts, giving you the potential for higher returns. In exchange for that potential upside, the account’s value can fluctuate based on how those subaccounts perform.

Fast Fact — Read the Fine Print: Because variable annuities let you choose how your premium is invested, it’s important to read the prospectus before investing. Variable annuities are sold by prospectus, which details investment objectives, risks, charges, and expenses. You’re encouraged to read it carefully — available from the insurance company or your financial professional — before sending money to purchase a contract. Subaccount values fluctuate with market conditions and may be worth more or less than your original investment when the annuity matures.

Indexed Annuities

Indexed annuities are a specialized type of variable annuity. During the accumulation period, your rate of return is tied to the performance of a market index.

Annuity Fees, Charges, and Surrender Charges

Annuities come with contract limitations, fees, and charges you should understand before purchasing, including:

• Account and administrative fees
• Underlying investment management fees
• Mortality and expense fees
• Charges for optional benefits/riders

Surrender charges are one of the most important costs to know about. Most annuities charge a surrender fee if you withdraw money early, and this fee is typically highest in the initial years of the contract, decreasing over time.

Other tax considerations:

• Withdrawals and income payments are taxed as ordinary income.
• Withdrawals made before age 59½ may trigger a 10% federal income tax penalty, unless an exception applies.
• Annuity guarantees depend entirely on the issuing insurance company’s claims-paying ability. Annuities are not guaranteed by the FDIC or any other government agency.