A temporary annuity is an insurance contract that pays you a fixed stream of income for a set number of years and then stops. Terms typically run from 5 to 20 years, and the contract names the exact start and end dates at purchase. People most often use one as bridge income, covering the gap between an early retirement date and the day Social Security or a pension begins. Because the insurer only commits to paying for a defined window rather than for life, the individual payments tend to be larger than what a life annuity funded with the same premium would produce.1
The Term-Certain Structure
Every temporary annuity runs on what insurers call a “term certain” framework. You pick a duration at the outset, the insurer locks in a payment schedule, and the contract expires on a specific calendar date whether you are still alive or not. That hard stop is what separates this product from a life annuity, which keeps paying as long as you are breathing.
If you die before the term ends, the remaining payments go to whoever you named as beneficiary. The insurer does not keep the leftover value. Your heirs collect every scheduled payment through the end of the original term.
Federal tax law backs this up. If you die before the annuity starting date, the remaining interest in the contract must be distributed within five years of your death. If you die after payments have already begun, the remaining payments must continue at least as quickly as they were being made at the time of death.
The Three Payout Types
The size and stability of your payments depends on which version of the product you buy. Three models dominate the market.
Fixed Payouts
A fixed temporary annuity pays the same dollar amount every period for the entire term. The insurer sets that figure based on your premium and the interest rate environment at purchase. You get maximum predictability. The obvious cost: if inflation runs at 3% a year, a $1,000 monthly payment buys noticeably less in year ten than in year one. Some contracts offer a cost-of-living rider that raises payments annually, but the rider lowers the starting payment.
Variable Payouts
Variable annuities tie your payments to the performance of underlying investment sub-accounts holding stocks, bonds, or both. You pick the sub-accounts at purchase, and each payment rises or falls with those investments. That opens a path to growing income, but payments can shrink in a market downturn. Variable contracts also carry higher internal fees, with mortality and expense risk charges alone averaging around 1.25% of sub-account assets a year.
Indexed Payouts
Indexed annuities sit between the other two. Payments are linked to a market index such as the S&P 500, so credited interest goes up when the index does. The contract includes a floor, often 0%, so a down year does not eat into principal. The tradeoff is a cap or participation rate limiting how much of the index gain you actually receive. If the S&P 500 rises 15% but your participation rate is 60%, you are credited 9%.
How the Payment Amount Is Set
The insurer uses three inputs to calculate your payment: the premium you pay in, the interest rate credited to the contract, and the length of the term. The math is built so the account reaches exactly zero on the last scheduled payment date.
Term length is the biggest lever. If you put $100,000 into a five-year contract, each monthly check will be substantially larger than if you spread the same $100,000 over twenty years. The credited rate also matters, but it moves the number less than the term does. Most insurers will hand you an illustration showing projected payments under different term options before you commit.
Fees That Reduce What You Receive
Surrender Charges
If you cash out before the term ends, the insurer imposes a surrender charge. A common schedule starts at 7% to 10% of the account value in year one and drops about one percentage point a year until it hits zero, usually in year seven or eight. Most contracts let you withdraw up to 10% of the account value each year without triggering the charge, but anything beyond that gets penalized. The surrender period is a liquidity trap, and it is the single most common source of regret among buyers who did not fully understand the contract.
Internal Fees on Variable Contracts
Variable annuities stack ongoing charges on top of surrender fees. The mortality and expense risk charge typically runs about 1.25% of sub-account assets a year. Add administrative fees and the expense ratios of the underlying sub-accounts, and total annual costs on a variable contract can exceed 2% to 3%. Fixed and indexed annuities generally show lower explicit fees because the insurer bakes its costs into the credited rate or participation rate instead.
State Premium Taxes
Most states tax the initial annuity premium, typically at 1% to 3.5% depending on the state. The insurer usually deducts this from your premium before investing it, so you start with slightly less than the amount you handed over.
How Payments Are Taxed
Annuity taxation is governed by Internal Revenue Code Section 72. How much tax you owe on each payment depends on whether you funded the contract with pre-tax or after-tax dollars.
Nonqualified Annuities and the Exclusion Ratio
If you bought the annuity with after-tax money, each payment splits into two parts: a tax-free return of your original premium and a taxable earnings portion. The IRS uses the exclusion ratio to determine the split. For a term-certain annuity, you divide your total investment in the contract by the expected return, which is the number of payments times the payment amount. The result is the percentage of each payment that comes out tax-free. Once you have recovered your full investment, every subsequent payment becomes fully taxable.
Qualified Annuities Are Fully Taxable
If the annuity sits inside a tax-deferred retirement account like a 401(k) or traditional IRA, the entire payment is generally taxable as ordinary income. The money went in pre-tax, so the exclusion ratio treatment does not apply. The IRS requires the Simplified Method rather than the General Rule for qualified accounts, and in practice the excludable portion is zero or negligible when all contributions were pre-tax.
The 10% Early Withdrawal Penalty
Pull money from an annuity before age 59½ and the IRS adds a 10% additional tax on top of the regular income tax owed on the taxable portion. The penalty applies to the earnings component, not to the return of your premium. Exceptions exist for disability, for payments structured as a series of substantially equal periodic payments over your life expectancy, and for a handful of other narrow situations.
Section 1035 Exchanges
You can swap one annuity contract for another without triggering a taxable event through a 1035 exchange. The rule also allows exchange of an annuity for a qualified long-term care insurance contract. The exchange must be a direct transfer between insurers. Take the cash yourself and buy a new annuity with it, and the IRS treats the first step as a taxable distribution. The provision is most useful when you find a contract with better terms or lower fees and want to move without a tax hit.
Beneficiary Taxation
When a beneficiary inherits remaining payments from a term-certain annuity, the tax treatment mirrors what the original annuitant would have owed. The beneficiary applies the same exclusion ratio to each payment, excluding the tax-free return-of-premium portion and paying ordinary income tax on the rest. Once the full investment in the contract has been recovered across all payments to both the original annuitant and the beneficiary, all remaining payments become fully taxable.
Buying the Contract
Suitability Review
Before recommending an annuity, a broker or agent must evaluate whether the product actually fits your situation. For securities-based annuities like variable contracts, FINRA Rule 2111 requires the broker to gather your investment profile, including age, financial situation, tax status, objectives, time horizon, liquidity needs, and risk tolerance, and to have a reasonable basis to believe the annuity is suitable based on that information. If you refuse to provide it, the broker cannot guess and proceed. Be honest during this review about how soon you might need access to the money. An annuity with a seven-year surrender period is a poor fit for someone who might need the cash in two.
The Free Look Period
Once your contract is issued, you get a window to change your mind. The free look period lets you cancel and receive a full refund of your premium. Duration varies by state, but most mandate at least 10 days, and many extend the period to 20 or 30 days for buyers over 60 or 65. Once the window closes, you are locked in and subject to surrender charges if you want out early.
Two Things People Miss
Medicaid and SSI Eligibility
Annuity income and assets can affect eligibility for means-tested government benefits. For Medicaid long-term care eligibility, buying an annuity converts a lump sum, which counts as an asset, into an income stream. That sounds helpful for meeting asset limits, but the monthly income still counts toward Medicaid’s income threshold, and payments large enough to push you over that limit can cost you eligibility entirely. Qualified annuities inside retirement accounts are generally not counted as assets for Medicaid, but the required distributions from those accounts are counted as income. The interaction is complex enough to warrant professional guidance before purchase.
If the Insurer Fails
Every state operates a life and health insurance guaranty association that steps in if your carrier becomes insolvent. Under the model most states use, the standard coverage limit for annuity benefits is $250,000 in present value per contract owner per insurer. Some states set higher limits. Payments continue up to that cap even if the company behind the contract goes under, but a premium larger than $250,000 with a single carrier leaves the excess unprotected. Splitting a large premium across multiple insurers keeps each contract inside the coverage limit.