How Annuities Work: Phases, Taxes, and Payout Rules

An annuity is a contract with an insurance company: you hand over a premium, and the insurer promises to pay you income on a schedule you choose, often for the rest of your life. That is the entire product in one sentence, and it is also the clearest way to understand how annuities work — everything else is a variation on when you pay, how the money grows in the meantime, how the income comes back out, and what it costs you along the way. The core appeal is protection against outliving your savings. The core trade-offs are limited access to your money, layered fees, and a 10 percent federal tax penalty on earnings withdrawn before age 59½.¹

Four roles sit inside every contract: the insurer that issues it and owes the payments, the owner who buys it and controls it, the annuitant whose life expectancy sets the payment math, and the beneficiary who receives whatever is left at death. One person usually fills both the owner and annuitant slots, but the contract treats them separately.

The Two Phases: Accumulation and Distribution

A deferred annuity moves through two stages, and understanding the split explains almost everything else about the product.

During the accumulation phase, you fund the contract with either a single lump sum or a series of premiums. The insurer credits earnings to your balance based on the contract type, and that balance grows tax-deferred. This phase can last a few years or a few decades. Your account value at any point is total premiums plus credited earnings, minus fees and any prior withdrawals. You can usually take partial withdrawals, add more money if the contract allows it, or surrender the contract altogether, though pulling money out early triggers surrender charges and, before age 59½, the federal tax penalty.

The distribution phase begins when you annuitize. Annuitization is the moment the insurer converts your accumulated balance into a binding stream of income payments. The check amount depends on your account value, the annuitant’s age, and the payout structure you pick. Once annuitization starts, the contract is generally irrevocable. You can no longer pull out a lump sum, change the terms, or walk away. The product flips from a savings vehicle into an income vehicle, and the choices you made a moment before annuitizing lock in for good.

How Your Balance Grows

Three contract types divide up the investment risk between you and the insurer differently.

A fixed annuity guarantees a specific interest rate for a set period, typically two to ten years. When that period ends, the insurer sets a new rate that will not fall below a contractual minimum (often 1 to 3 percent depending on the product and state). You take no market risk. Your upside is capped at whatever the insurer promises.

A variable annuity lets you allocate premiums into investment sub-accounts that hold stocks, bonds, and other securities, similar to mutual funds. Your balance rises and falls with the market. There is no guaranteed return, and you can lose principal. Variable annuities are securities regulated by the SEC, which adds disclosure requirements and generally means higher fees.

An indexed annuity ties your earnings to a market index like the S&P 500, but with limits on both sides. A participation rate determines what percentage of the index’s gain gets credited to you — an 80 percent participation rate on a 10 percent index gain credits you 8 percent. A cap sets a hard ceiling on interest credited in a period. A floor (often zero) protects your principal from index losses. The interaction between participation rates, caps, and crediting methods makes indexed contracts harder to evaluate than they look.²

How the Income Comes Back Out

When you annuitize, you pick a payout structure. This choice controls how long payments last and what happens if you die before the money runs out. Three options dominate the market:

Life only (straight life). Payments continue as long as you live and stop the moment you die. Nothing passes to a beneficiary. Because the insurer’s obligation ends with your life, this option produces the highest per-payment amount.
Period certain. Payments are guaranteed for a fixed number of years, commonly 10 or 20. If you die inside that window, your beneficiary receives the remaining payments. If you outlive the window, payments stop.
Joint and survivor. Payments continue until both you and a second person, usually a spouse, have died. Some versions cut the payment after the first death; others do not. Individual payments are smaller because the insurer must plan for two lifetimes.

The choice is permanent once annuitization begins. Married couples who pick life-only for the bigger check can leave a surviving spouse with nothing.

Immediate vs. Deferred: When Payments Start

Beyond how the balance grows, the other major structural fork is when the income begins.

An immediate annuity takes a single lump-sum premium and starts paying income within 12 months. There is essentially no accumulation phase. The insurer runs the actuarial math against your current age and starts sending checks. The typical buyer is a retiree converting a savings balance into cash flow right away.

A deferred annuity postpones income to a future date you select. Fund it at 50, start payments at 65, and the contract compounds for 15 years before turning on. The longer you wait, the larger each payment, because the balance grows and the insurer covers a shorter expected payout period. The trade-off is that you need other income sources in the meantime.

What It Costs

Annuity fees vary sharply by contract type. Fixed annuities have the simplest cost structure — expenses are baked into the spread between what the insurer earns on your money and the rate it credits to you. Variable and indexed contracts add explicit charges that can erode long-term returns.

Variable annuities are the most expensive category. The mortality and expense (M&E) risk charge, which pays the insurer for guaranteeing a death benefit and covering administration, averages roughly 1.15 to 1.25 percent of account value per year, though fee-based contracts can come in below 0.50 percent. On top of that, you pay the operating expenses of the underlying sub-accounts and any administrative fees. Optional riders — guaranteed lifetime income, enhanced death benefits, long-term care access — each add another 0.25 to 1 percent. FINRA requires your broker to disclose these charges before you buy.³ All in, a variable annuity investor can lose 2 to 3 percent of account value per year to expenses.

Nearly every deferred annuity imposes surrender charges on money pulled out during the early years. Most contracts let you withdraw up to 10 percent of account value each year without penalty. Above that, a declining schedule applies. A common structure starts at 7 percent of the withdrawn amount in year one and drops one point annually until it reaches zero in year eight. Some contracts also apply a market value adjustment on early surrender. If interest rates have risen since you bought the annuity, the adjustment reduces your payout further. If rates have fallen, it works in your favor.

How Annuity Income Is Taxed

Tax-deferred growth is one of the main reasons people buy annuities. Interest, dividends, and gains earned inside the contract are not taxed while they stay there.¹ You owe income tax when money comes out, and how it comes out changes the math.

Annuitized payments get exclusion-ratio treatment. Each payment is split into a tax-free return of your original premium and a taxable portion representing earnings.¹ Pay $100,000 in premiums, and if the insurer expects to distribute $200,000 over your lifetime, half of each check is tax-free and half is taxable. Once you have recovered your entire premium, every subsequent payment is fully taxable.

Withdrawals taken before annuitization get worse treatment. The IRS applies an earnings-first rule: every dollar you pull out counts as taxable income until all accumulated gains have come out. Only then do withdrawals start returning your after-tax premium tax-free.¹ All taxable amounts from annuities are taxed as ordinary income, not at capital gains rates.

The rules above describe non-qualified annuities, bought with money you have already paid income tax on. A qualified annuity is one held inside a tax-advantaged retirement account like an IRA or 401(k). Because the premiums were pre-tax, there is no basis to recover — the entire withdrawal is taxable as ordinary income, and no exclusion ratio applies.⁴⁵⁶ Non-qualified annuities are not subject to RMD rules.

The 10 Percent Early Withdrawal Penalty

Pull money from an annuity before age 59½ and the IRS tacks a 10 percent penalty onto the regular income tax owed on the taxable portion.¹ The main exceptions:

Distributions after the contract holder dies.
Withdrawals after you become disabled as defined by the tax code.
A series of substantially equal periodic payments over your life expectancy, once started, continued for at least five years or until you reach 59½, whichever is later.
Payments from an immediate annuity that begins income within a year of purchase.

These exceptions apply to the federal penalty only. Surrender charges are a separate contractual matter and still apply.

1035 Exchanges: Swapping Contracts Without a Tax Bill

If your current annuity has become too expensive or is no longer a good fit, you can swap it for a new annuity from a different insurer without triggering tax on the gains. This is a 1035 exchange, named after the tax code section that authorizes it.⁷ The transfer must go directly from the old insurer to the new one. If the money passes through your hands, the exchange fails and gains become taxable.⁸ The same person must be the owner on both contracts. The new contract also starts a fresh surrender charge schedule, so run the math before switching.

What Happens If You Die

Die during the accumulation phase and most contracts pay a death benefit to your named beneficiary. The standard benefit equals your account value: premiums plus earnings, less fees and prior withdrawals. Optional riders (at extra cost) can guarantee a minimum payout equal to total premiums even if investment losses have reduced the account.

For non-qualified annuities, the tax code sets specific distribution timelines when the owner dies before the contract has been fully paid out. If death occurs before annuitization, the entire remaining interest generally must be distributed within five years. A named beneficiary can instead stretch distributions over their own life expectancy if payments begin within one year of the owner’s death. A surviving spouse who is the beneficiary can step into the owner’s shoes and continue the contract as their own.¹

Die after annuitization and the outcome depends on the payout option. A life-only annuity stops paying. A period-certain or joint-and-survivor contract continues to the beneficiary or surviving co-annuitant for the remaining guaranteed period. That is one of the strongest reasons to accept a smaller monthly payment in exchange for a payout structure that outlives you.

What Backs the Insurer’s Promise

Annuities are not FDIC-insured. They are backed by state insurance guaranty associations, nonprofit entities created by state law to cover policyholders if an insurer fails. Every state, the District of Columbia, and Puerto Rico operates one. Coverage limits for the present value of annuity benefits range from $100,000 to $500,000 depending on the state, with $250,000 the most common threshold.⁹

Limits apply per insurer, so spreading large holdings across carriers can raise your total protected amount. Some states also impose aggregate caps across all policy types held with the same failed insurer. Guaranty coverage is a backstop, not a substitute for checking an insurer’s financial strength ratings from A.M. Best or S&P before buying.

Your Window to Cancel: The Free Look Period

After buying an annuity, you have a limited window to cancel the contract for a full premium refund with no surrender charge. State laws set the length, and the range across all states runs from 10 to 30 days. The NAIC model regulation recommends a minimum of 15 days when disclosure documents were not provided at application.¹⁰ Many states extend the window to 20 or 30 days for buyers over 65 or for contracts that replace an existing annuity. Once the free look period closes, you are inside the contract’s surrender charge schedule. Read the full terms during that window, not after it.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
FINRA.org. The Complicated Risks and Rewards of Indexed Annuities
3
FINRA.org. FINRA Rules – 2330 Members’ Responsibilities Regarding Deferred Variable Annuities
4
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
5
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
6
Internal Revenue Service. Retirement Topics – Required Minimum Distributions (RMDs)
7
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
8
Internal Revenue Service. Revenue Ruling 2003-76, Section 1035 Certain Exchanges of Insurance Policies
9
NOLHGA. Guaranty Association Laws
10
NAIC. Annuity Disclosure Model Regulation