A retirement annuity works by turning a pile of savings into a stream of income you can’t outlive. You pay an insurance company either a lump sum or a series of premiums, the money grows tax-deferred while it sits inside the contract, and then the insurer pays you back in periodic installments whose size depends on your age, the payout option you pick, and how the contract was designed to grow. Taxes come due only when money comes out, and the rules for that depend on whether the annuity was bought with pre-tax or after-tax dollars.
That is the whole arc. The rest is detail, and the detail is where people lose money.
Who’s Who in the Contract
Every annuity has three roles. The owner buys the contract, controls investment choices, names beneficiaries, and decides when income begins. The annuitant is the person whose life expectancy the insurer uses to size the payments. The beneficiary receives whatever value is left if the annuitant dies while the contract still holds funds. Owner and annuitant are usually the same person, though estate planners sometimes split them.
Building the Balance: The Accumulation Phase
During accumulation, you fund the contract. A single-premium annuity takes one lump sum; a flexible-premium annuity accepts smaller deposits over time. The insurer invests the money, and earnings compound without triggering annual income tax. That deferral is the central tax feature: the balance grows faster than it would in a taxable account earning the same rate because nothing is siphoned off each April.
How the money grows depends on the type of annuity you buy.
Fixed Annuities
A fixed annuity pays a guaranteed interest rate for a set term. Your principal is protected and the insurer carries the investment risk. You give up any chance of market-driven upside beyond the declared rate.
Variable Annuities
Variable annuities let you allocate money to sub-accounts that behave like mutual funds. Your balance rises and falls with the markets, and the investment risk sits with you. Fees are typically higher than in other annuity types, which matters over decades of compounding.
Fixed Indexed Annuities
Fixed indexed annuities tie your credited interest to a market index like the S&P 500, but limit how much of the gain you actually see. The three common levers are:
- Cap: a ceiling on returns. If the index gains 12% and the cap is 6%, you get 6%.
- Spread: a fixed percentage subtracted from the index return. An 8% gain minus a 3% spread credits 5%.
- Participation rate: the share of the index gain that counts. A 70% rate on a 10% gain credits 7%.
These contracts typically include a 0% floor, so in a losing year the worst outcome for your principal is no credited interest.1Fidelity. What Is a Fixed Indexed Annuity?
What the Contract Costs You
Annuity fees are usually invisible because they come out of the account rather than a separate bill. They still reduce what you keep.
Variable annuities carry the heaviest load. The mortality and expense risk charge alone runs about 1.25% of account value per year.2SEC.gov. Variable Annuities: What You Should Know Sub-account investment fees stack on top, and an optional guaranteed income rider can push total annual costs to roughly 3% or more. Over 20 years, that compounds into real money.
Fixed and fixed indexed annuities don’t itemize annual fees the same way. The insurer’s margin is baked into the interest rate or the cap, spread, and participation rate. Income riders on these contracts typically add 0.25% to 1.5% of contract value per year.
Surrender Charges
Insurers design annuities to sit for years, and they enforce the expectation with surrender charges. Pull money out or cancel during the surrender period and you pay a percentage of what you withdraw. The period usually runs six to ten years, with fees often starting at 6% to 8% and stepping down annually to zero.3Investor.gov. Surrender Charge
Most contracts allow a free withdrawal of up to 10% of account value each year without triggering the charge. Go past that limit and the fee applies to every dollar over.
Some fixed and indexed contracts add a market value adjustment when you surrender early. If interest rates have risen since you bought the annuity, the adjustment is typically negative and cuts your proceeds on top of the surrender charge.4Investor.gov. Registered Market Value Adjustment (MVA) Annuity Together, the two can take a substantial bite out of an early exit.
Turning the Balance Into Income
Annuitization converts your accumulated value into payments. The structure you pick sets both the monthly amount and what happens if you die early. Once you annuitize, the choice is generally permanent.
- Life only pays the highest monthly amount because the insurer covers one life with no guarantees after death. If you die two years in, the remaining balance stays with the company.
- Joint and survivor covers two lives, usually spouses. Payments continue for the survivor, often at a reduced percentage such as 50%, 75%, or 100% of the original. Starting payments are lower because the insurer expects to pay longer.
- Period certain guarantees payments for a fixed span such as 10, 15, or 20 years. If you die before it ends, your beneficiary collects the rest. It’s sometimes used to bridge the gap between early retirement and the start of Social Security.
- Life with period certain combines lifetime income with a minimum guarantee. Payments run for your life, but if you die within the guaranteed period the beneficiary receives the remaining payments.
QLACs
A qualified longevity annuity contract is a deferred income annuity bought inside a qualified retirement account. You purchase now and delay income until as late as age 85. Money placed in a QLAC is excluded from required minimum distribution calculations, which can lower taxable income earlier in retirement. For 2026, the maximum QLAC purchase is $210,000.5Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs
How Distributions Are Taxed
The tax treatment of an annuity payment turns on two things: whether the contract is qualified or non-qualified, and whether you’re taking scheduled annuity payments or a partial withdrawal.
Qualified Annuities
A qualified annuity lives inside a tax-advantaged account like a traditional IRA, 401(k), or 403(b). Contributions went in pre-tax, so the entire distribution comes out as ordinary income. For 2026, federal rates range from 10% to 37% depending on total taxable income.6Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
Non-Qualified Annuities
A non-qualified annuity is bought with after-tax dollars outside a retirement account, and how you take the money matters.
If you annuitize and receive regular periodic payments, the IRS applies an exclusion ratio. Your original investment divided by total expected lifetime return produces a percentage of each payment that comes back tax-free as return of principal; the rest is taxable ordinary income.7Internal Revenue Service. Publication 939 – General Rule for Pensions and Annuities Once you’ve recovered your full cost basis, every later payment is fully taxable.
If you take a partial withdrawal before annuitizing, the rule flips against you. The IRS treats withdrawals as earnings first: every dollar you pull out is taxable until the gains in the contract are exhausted. Only after that do withdrawals dip into your tax-free principal.8Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts This is one of the most common surprises for owners who dip in before starting a formal income stream.
The 10% Early Withdrawal Penalty
Any taxable withdrawal taken before age 59½ triggers an additional 10% federal penalty on top of regular income tax, whether the contract is qualified or not.8Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts The penalty is separate from any surrender charge the insurance company imposes. Narrow exceptions apply, including death, disability, and substantially equal periodic payments under IRS rules.
Net Investment Income Tax
Higher earners face one more layer. The taxable portion of distributions from non-qualified annuities counts as net investment income, subject to a 3.8% surtax if your modified adjusted gross income exceeds $200,000 for single filers, $250,000 for joint filers, or $125,000 for married filing separately.9Internal Revenue Service. Net Investment Income Tax Distributions from qualified retirement plans are generally exempt. Stacked together, ordinary income tax, the 10% penalty, and the 3.8% surtax explain why early withdrawals from non-qualified contracts get expensive fast.
Required Minimum Distributions
If your annuity sits inside a qualified plan or traditional IRA, required minimum distributions start at age 73.10Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs Under SECURE 2.0, that age rises to 75 for people who turn 73 after December 31, 2032. If you’re still working and don’t own 5% or more of your employer, workplace plans like a 401(k) let you delay RMDs until the year you actually retire.
Missing an RMD carries a 25% excise tax on the shortfall. Correct the mistake within two years and the penalty drops to 10%.10Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs Non-qualified annuities aren’t subject to lifetime RMDs.
What Happens When the Annuitant Dies
Most deferred annuities include a guaranteed minimum death benefit. If the annuitant dies during accumulation, the beneficiary receives at least the total premiums paid minus prior withdrawals, even if market value has dropped below that amount. Some contracts offer enhanced death benefits for an added fee.
A surviving spouse can typically assume ownership, keep the tax deferral intact, and either continue accumulation or begin taking income. Non-spouse beneficiaries generally have to take the full payout within a defined period and cannot assume ownership. In both cases, gains above the original cost basis are taxable as ordinary income when received.
If the annuitant dies after annuitization begins, the payout option chosen earlier controls what happens. Life only stops immediately with no death benefit. Joint and survivor keeps paying the spouse. Period certain pays the remainder to the named beneficiary. That choice at annuitization has lasting consequences for the family.
If the Insurer Fails
Annuities aren’t backed by the FDIC. Every state runs a guaranty association that steps in if an insurance company becomes insolvent, covering the present value of annuity benefits up to a limit set by state law. The most common ceiling is $250,000, with coverage running from $100,000 to $500,000 depending on the state.11NOLHGA. How You’re Protected Large balances can be split across multiple highly rated insurers to stay under the ceiling.
The Best-Interest Standard for Agents
Insurance agents recommending annuities are held to a best-interest standard under a model regulation developed by the National Association of Insurance Commissioners. As of 2025, 48 states have adopted it, requiring that any annuity recommendation be in the consumer’s best interest and that agents cannot put their own compensation ahead of the buyer’s needs.12NAIC. Annuity Suitability and Best Interest Standard If an agent is pushing a product with steep surrender charges, high rider fees, and a long lock-up when a simpler product would meet your goals, you can ask them to document in writing why that specific annuity is in your best interest before you sign.