What Is an Annuity? A Plain-English Guide

An annuity is a contract between you and an insurance company: you give them a lump sum (or a series of payments), and they promise to pay you income — either immediately or at some future date. At its core, an annuity is a way to convert savings into a paycheck you can't outlive. But not all annuities are created equal, and the wrong one can cost you dearly.

The Two Main Types of Annuities

Immediate Annuities

You hand over a lump sum today, and payments start within a month or year. Common among retirees who want to convert a portion of their savings into guaranteed monthly income. A 65-year-old with $200,000 might receive $1,100–$1,300/month for life, depending on the insurer and payout option.

Deferred Annuities

You invest now, and income starts later — often at retirement. There are three subtypes:

• Fixed annuity: Guaranteed interest rate, similar to a CD but with insurance protection
• Variable annuity: Returns tied to investment subaccounts (like mutual funds) — higher potential, higher risk
• Fixed indexed annuity: Returns linked to a market index (S&P 500) with a floor of 0% — you can't lose principal but gains are capped

How Annuity Payouts Work

When you 'annuitize,' you choose a payout option:

• Life only: Highest monthly payment, but stops when you die (even if you die after one payment)
• Life with period certain: Pays for life, but guarantees payments for at least 10 or 20 years (payments go to beneficiaries if you die early)
• Joint and survivor: Continues paying your spouse after you die, at 50% or 100% of the original amount
• Fixed period: Payments for a set number of years, not tied to your lifespan

The Tax Treatment of Annuities

Annuities grow tax-deferred — you don't pay taxes on gains until you withdraw. If you funded the annuity with after-tax dollars, only the earnings portion of each payment is taxable. If you used pre-tax money (like a rollover from a traditional IRA), the entire payment is taxable as ordinary income.

Annuity Fees: The Hidden Cost

Variable annuities in particular carry significant fees:

• Mortality and expense (M&E) fees: 1.0–1.5% per year
• Investment management fees: 0.5–2.0% per year on subaccounts
• Rider fees: 0.5–1.5% per year for guaranteed income or death benefit riders
• Total: Often 2–4% annually — far more than low-cost index funds

When an Annuity Makes Sense

• You're worried about outliving your money (longevity risk)
• You have no pension and want guaranteed income beyond Social Security
• You've maxed out 401(k) and IRA contributions and want more tax-deferred growth
• You're buying a simple immediate annuity or fixed annuity (lower fees)

When to Be Cautious

• High-fee variable annuities sold by commission-based advisors
• You may need the money before age 59½ (10% penalty plus surrender charges)
• Surrender periods of 7–10 years that lock up your money
• You're young — the tax-deferral benefit matters less with decades of growth ahead