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Annuities Guide: What Are Annuities and How Do They Work?

Annuities Guide: What Are Annuities and How Do They Work?
Holly Johnson
Updated October 12, 2021
7 Min Read

There are myriad financial products you can use to plan for retirement, yet there are pros and cons to consider no matter which path you take. Annuities are one of the more popular financial products for financial planning, mostly because they can provide safety, long-term growth, and a source of passive income that could last the rest of your life.

Even so, annuities are one of the more complex retirement planning strategies out there, and there are many types of annuities to consider, each of which comes with its own upsides and downsides. This guide aims to explain what annuities are, how they work, the different types of annuities, and everything you should consider before you get started with this type of insurance contract.

What Is an Annuity?

According to Investor.gov, an annuity is "a contract between you and an insurance company that is designed to meet retirement and other long-range goals, under which you make a lump-sum payment or series of payments." In exchange for investing in an annuity, the insurance company agrees to make periodic payments to you starting right away, or even on a future date both parties agree upon.

With that in mind, it's easy to see why annuities are attractive to future retirees. You may make a lump sum payment or a series of payments toward an annuity contract, yet you will ultimately receive periodic payments you can use to cover living expenses and enjoy the retirement you've worked for. 

There are other benefits to look forward to with an annuity as well, including some upside when it comes to taxes. Generally speaking, annuities are built to provide tax-deferred growth on the earnings you accrue, and it's possible a death benefit will be included in your plan. 

However, it's important to note that gains withdrawn from an annuity are taxed at ordinary income rates instead of capital gains rates. Further, annuities are not always easy to get out of if your plans change. If you need to withdraw your money early, chances are good you'll have to pay penalties as well as a surrender charge to the insurance company you bought your annuity from.

How Do Annuities Work?

How annuities work depends a lot on the type of annuity you invest in. However, there are some common factors that typically apply to all types of annuities. For example, annuities can do the following:

  • Provide you with guaranteed income for life
  • Provide you with access to your funds, up to preset limits
  • Give you the chance to leave money for your heirs

Remember that you pay for your annuity upfront, either with a lump sum payment or a series of payments. In exchange for that purchase, you will receive payments for your entire lifetime or a specified timeline, which most people use to fund their retirement and regular expenses. 

With that in mind, some see annuities as an alternative way to save for retirement that can work well once you've maxed out other tax-deferred investment options. Annuities can also help you "catch up" on retirement savings when you are running out of time. 

Types of Annuities

The type of annuity you purchase plays a huge role in how they work, as well as the type of investor they are geared to. Generally speaking, there are three main types of annuities to consider — fixed, indexed, and variable. 

  • Fixed Annuities: Fixed annuities are typically chosen by investors who want some stability in their payments and the amount of interest they earn. With a fixed annuity, the insurance company agrees to pay you no less than a specific rate of interest while your account is accruing interest. Not only that, but periodic payments are agreed upon for a specific length of time, such as 20 years or the rest of your lifetime. Your fixed annuity could even last for the length of your spouse's lifetime.
  • Indexed Annuities: Indexed annuities are typically chosen by investors who are willing to take on more risk in exchange for higher upside potential. With an indexed annuity, the insurance company agrees to pay you a return based on an index, such as the S&P 500. While indexed annuities can be set up differently, most set a limit on the potential upside you can get when the index performs well while also setting a minimum rate of return that protects investors when markets perform poorly. Indexed annuities may or may not be a security, and thus may or may not be regulated by the Securities and Exchange Commission (SEC).
  • Variable Annuities: Variable annuities are geared to investors who want to have ultimate control over where their money is invested. With a variable annuity, investors are able to choose where their money goes, with mutual funds as a major option to consider. As such, the interest earned by the annuity, as well as the future payments, depend on the return of the underlying investments. Also note that variable annuities are securities, and thus they are regulated by the SEC.

The timeline on which you can receive annuity payments can vary. With an immediate annuity, you can begin receiving guaranteed payments as soon as you make your initial payment. Meanwhile, deferred annuities let your investment grow on a tax-deferred basis with the goal of receiving payments sometime in the future. 

How Are Annuities Taxed?

The tax rules for annuities depend on the type of annuity you invest in and when you begin receiving payments. Taxes also vary depending on where the money you used to invest in an annuity comes from.

For example, you could potentially invest in a "qualified annuity" with IRA funds or money in your 401(k), which would be pretax. In that case, all of the payouts from your annuity would be taxed at your ordinary income tax rate (and not at the capital gains rate). 

If you use after-tax dollars to buy a "non-qualified annuity," then part of the payouts from your annuity will be tax-free. If you buy an annuity with funds in a Roth IRA or Roth 401(k), then it's possible to escape federal income taxes entirely.

How do Annuities Fit with Life Insurance?

While plenty of major financial institutions offer annuities, life insurance companies do as well. This makes a lot of sense since life insurance companies offer products that pay guaranteed income upon death, and annuities offer guaranteed income during retirement years. 

While these products are vastly different, actuaries use the same types of data to determine the risk and pricing of both types of products. Life insurance products base your premiums on your chances of mortality, yet annuities are priced based on the other side of the coin — how long you might live and receive payments. With both annuities and life insurance, the life insurance company tries to turn a profit by using actuarial data to determine how long you are expected to live.

Is an Annuity a Good Investment?

Just like with other financial products, annuities can be a smart choice or an incredibly poor option. That's why, by and large, you should do plenty of research on annuities and their alternatives before you buy one — or before you speak with an agent that sells annuities for high commissions.

Generally speaking, there is a type of consumer annuities can make sense for:

  • Annuities can be a good option for people who want guaranteed income in retirement. The regular payments annuities guarantee can be a boon for retirement savers who want a concrete plan and a stream of passive income.
  • People who want tax-deferred growth can benefit from annuities. Remember that the money you contribute to an annuity is able to grow on a tax-deferred basis. Further, you never owe money on an annuity until you take money out.
  • You may get a death benefit. While you can always pair an annuity with life insurance, it's possible to build a death benefit into an annuity. While annuity products vary, death benefits can be equal to the amount of money you have paid into your annuity. 

Downsides of Annuities

While annuities can be fruitful for people who do their research and make an informed decision, there are plenty of major downsides to be aware of. For starters, many annuities come with pricey fees that make them expensive. For example, your annuity may charge administration fees as well as mortality and expense risk fees. Variable annuities tend to have the highest fees, and thus they tend to be more risky than other options.

Also be aware of surrender charges you may have to pay if you need to access your money early. This type of charge can apply when you need to make more withdrawals than your annuity initially allowed. While surrender charges can vary, they can easily be as high as 6 percent of the withdrawal amount or more. This means that, if you need to make a $10,000 withdrawal from an annuity at a time when the surrender charge is 6 percent, you would owe $600 in fees right off the bat.

Finally, those considering an annuity should also consider the high commissions agents can earn for making a sale. This commission isn't paid directly by the person purchasing the annuity, but the potential for higher commissions can mean you'll get biased advice from a life insurance agent or a financial advisor.

While commissions can vary, many insurance companies that offer annuities pay the salesperson an upfront commission of 1 percent to 10 percent of the total contract amount. That could mean a commission of $1,000 to $100,000 on an annuity contract for $100,000.

Can You Lose Money with an Annuity?

Imagine you purchase a $250,000 annuity with immediate payments only to die within a few years. By and large, what happens next depends on the terms of the annuity you purchased, and the type of annuity it is. 

With some types of annuities, the life insurance company would keep your entire annuity payment. In other cases, however, the payments would continue to your spouse or another annuity beneficiary for a specified timeline.

As we mentioned already, some annuities are also set up to provide a death benefit that may be equal to the amount of your annuity contract or your current account balance. In this case, your beneficiary would receive a lump sum payment upon your death.

Also note that some types of annuities offer more risk of losing money. With a variable annuity, for example, you may risk losing your principal if the underlying investments you choose perform very poorly.

Who Should Buy an Annuity?

At the end of the day, buying an annuity is a personal choice that should be made after considering a wide range of factors. However, annuities are usually best for people who have already maximized other retirement options that may be available to them, including tax-deferred plans like the 401(k), SEP IRA, or Solo 401(k)

Annuities can also make sense for consumers who want guaranteed income for a set amount of time. Fixed annuities even offer returns with a fixed interest rate, so you know exactly the type of returns you'll get along the way.

Many people also think of annuities as an "easy" investment strategy since you have the potential to invest your money once and receive a guaranteed payout until the day you die. This strategy does come with some downsides, but you'll never have to worry about outliving your money if you choose an annuity that offers payments for life.

Finally, annuities can be a good option if you want to leave money to your heirs, although you'll need to choose an annuity that continues payments to beneficiaries after you die. Just remember that the payments your beneficiary receives will become taxable income to them, and that it's possible you could leave them more money if you invested your assets in another way.

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