An annuity is a contract with an insurance company: you pay money in now, either as a lump sum or over time, and the insurer promises to pay it back to you in regular installments later, usually during retirement. That is what an annuity is and how it works at its core. The product exists to protect you against outliving your savings, and the insurer can make that promise because it pools your money with thousands of other policyholders and spreads the risk of any one person living much longer than average. What varies from contract to contract is how your money grows, what you pay in fees, when the payments start, how long they last, and how the IRS taxes what comes out.
The Two Phases of an Annuity
Every annuity moves through two stages, and understanding them is the clearest way to see how the product works.
The first is the accumulation phase. You contribute money and the balance grows on terms set by the contract. Depending on the type of annuity, growth might come from a guaranteed interest rate, from stock market performance, or from an index-linked formula. No income taxes are due on those gains while they sit inside the contract, which lets the balance compound more efficiently than a taxable brokerage account would.
The second is the distribution phase, sometimes called annuitization. The insurer converts your accumulated balance into a stream of regular payments. When they start, how large they are, and how long they last depend on the payout option you chose. Some people annuitize immediately after buying; others let the balance grow for decades first. The shift from saving to receiving income is the whole point of the contract.
Types of Annuities
How your money grows during the accumulation phase depends on which type of annuity you buy. There are three main varieties.
Fixed Annuities
A fixed annuity pays a guaranteed interest rate for a set period, regardless of what the stock market does. The insurance company bears all the investment risk, so your balance grows on a predictable path. A subcategory called a multi-year guaranteed annuity, or MYGA, works like a certificate of deposit issued by an insurer: you pay a single premium, lock in a specific rate for a defined term of usually three to nine years, and the rate never changes during that term.
Variable Annuities
Variable annuities put your money into sub-accounts that function like mutual funds, investing in stocks, bonds, money market instruments, or a mix.1SEC.gov. Variable Annuities: What You Should Know Your balance rises and falls with market performance, so you carry the investment risk instead of the insurer. The potential for stronger long-term growth is real, but so is the possibility that your account value and future income will drop during a downturn. Variable annuities also carry the highest fees of any annuity type.
Indexed Annuities
Indexed annuities sit between fixed and variable. Returns are linked to a market benchmark like the S&P 500, but the insurer applies a formula that limits how much of the index’s gain you actually receive. A participation rate determines the percentage of the gain credited to your account, and a cap sets the maximum you can earn in a given period. If the index rises 12% and your cap is 7%, you get 7%. In exchange for giving up some of the upside, most indexed annuities include a floor that prevents your account from losing value in a down year.2FINRA. The Complicated Risks and Rewards of Indexed Annuities
When Payments Start and How Long They Last
Once the contract shifts into the distribution phase, two choices define the income stream: when it begins and how long it runs.
On timing, an immediate annuity, often called a single premium immediate annuity or SPIA, starts paying you within one month to one year after you hand over a lump sum. That fits someone already retired who needs income now. A deferred annuity delays payments to a future date, giving your balance years or decades to grow first. Buyers in their 40s or 50s typically choose deferred contracts.
On duration, the payout structure determines how long payments continue and who receives them:
- Life only: payments continue for as long as you live and then stop. No beneficiary receives anything. Because the insurer isn’t guaranteeing payments after your death, the monthly amount is usually higher than the other options.
- Joint and survivor: payments continue for two lives, typically yours and your spouse’s. After the first person dies, the survivor keeps receiving payments until they also pass away. The monthly amount is lower because the insurer expects to pay longer.
- Period certain: payments are guaranteed for a fixed number of years, such as 10 or 20, regardless of whether you’re alive. If you die during that period, your beneficiary collects the remainder. If you outlive it, payments stop.
- Life with period certain: combines lifetime income with a guaranteed minimum period. Choose life with 10-year certain, die after six years, and your beneficiary receives payments for the remaining four. Live past year 10 and payments continue for your lifetime.
The choice is essentially a bet on how long you’ll live. Life only pays the most per check but leaves heirs with nothing. Period certain protects beneficiaries but may run out while you’re still alive. Joint and survivor or life with period certain is the safer middle ground for married couples.
What an Annuity Costs
Fees are where the different types of annuities diverge sharply, and where many buyers get caught off guard. Fixed annuities and MYGAs tend to have minimal explicit fees because the insurer’s profit is built into the interest rate spread. Variable annuities stack several layers of charges that can meaningfully erode returns.
Surrender Charges
If you withdraw money during the first several years of the contract, the insurer deducts a surrender charge. A common schedule starts at 7% in the first year and drops by one percentage point annually, reaching zero around year seven or eight. Most contracts let you pull out up to 10% of your balance each year without triggering the charge, but anything beyond that gets hit. Surrender periods generally run five to ten years depending on the contract.
Ongoing Fees
Variable annuities carry the heaviest ongoing fee load. The SEC identifies these main layers:1SEC.gov. Variable Annuities: What You Should Know
- A mortality and expense risk charge, typically around 1.25% of your account value per year, compensating the insurer for guaranteeing the death benefit and the annuitization option.
- Administrative fees, either a flat annual charge of roughly $25 to $30 or about 0.15% of account value.
- Underlying fund expenses, since the mutual fund sub-accounts charge their own management fees on top of the annuity-level charges.
- Rider fees for optional features like enhanced death benefits or lifetime income guarantees, which can add 1% to 3% more.
Total annual costs on a variable annuity with one or two riders can easily reach 3% or more of account value. That is a significant headwind for growth. Fixed and indexed annuities generally cost less because the insurer embeds its compensation in the interest rate or crediting formula rather than charging explicit fees.
Riders
Riders are optional add-on features that modify how the annuity behaves, and each carries its own annual fee. Enhanced death benefit riders can guarantee heirs a minimum payout even if your sub-accounts have lost money. A guaranteed lifetime withdrawal benefit (GLWB) lets you withdraw a set percentage of a “benefit base” every year for life, even if your actual balance drops to zero; withdrawal percentages typically range from about 3.25% to 5.75% depending on the age you start, and the rider itself generally costs 1% to 3% of the benefit base annually. A cost-of-living adjustment rider increases payments over time to offset inflation, in exchange for a noticeably lower starting payment.
How Annuities Are Taxed
The federal tax treatment of annuities is governed by Section 72 of the Internal Revenue Code.3Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts The core benefit during accumulation is tax deferral: your gains compound without an annual tax bill, and taxes come due only when money comes out.
If you take a withdrawal during the accumulation phase, before converting the account to a payment stream, the IRS treats the earnings portion as coming out first. Your early withdrawals are fully taxable as ordinary income until all gains have been withdrawn; only after that do you reach the tax-free return of your original investment.
Once you annuitize, the math changes. Each payment is split into a taxable portion (earnings) and a tax-free portion (return of your original investment) using the exclusion ratio. The formula divides your total investment in the contract by the expected return over the payment period. Invest $100,000 with an expected total return of $200,000, and 50% of each payment is tax-free and 50% is taxable as ordinary income.4Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
Withdrawals taken before age 59½ trigger a 10% additional tax on the taxable portion, on top of regular income tax. A few exceptions exist, including distributions due to disability and certain substantially equal periodic payments, but the penalty applies to most early withdrawals.
Qualified vs. Non-Qualified
The tax rules above depend on how the annuity was funded. A qualified annuity is funded with pre-tax dollars, typically inside an IRA or employer retirement plan. Because you never paid income tax on the contributions, the entire distribution is taxable as ordinary income when it comes out.5Internal Revenue Service. Publication 575, Pension and Annuity Income A non-qualified annuity is purchased with money you’ve already paid taxes on; only the earnings are taxable on withdrawal, and the exclusion ratio applies. Qualified annuities are also subject to required minimum distribution rules, which force annual withdrawals starting at age 73, or 75 if you were born in 1960 or later. Non-qualified annuities are not subject to those rules.
Moving Between Contracts
If you want to switch from one annuity to another without triggering taxes, a 1035 exchange lets you transfer the value of an existing annuity into a new annuity, or into a qualified long-term care insurance policy, with no gain or loss recognized.6Office of the Law Revision Counsel. 26 U.S. Code 1035 – Certain Exchanges of Insurance Policies The transfer must go directly between insurers; if the money passes through your hands, the IRS treats it as a taxable withdrawal. Moving to a new contract may also restart the surrender charge period.
Your Protections as a Buyer
Annuities are long-term commitments, and several rules exist to protect you at the point of sale and afterward.
After you receive the contract, most states give you a window to cancel and get a full refund of premiums paid, no questions asked. The standard free look period is 10 days, though some states extend it to 20 or 30, particularly for buyers age 65 and older.
Annuities are not backed by the FDIC. They are backed by the financial strength of the issuing insurance company. If the insurer becomes insolvent, your state’s guaranty association steps in. Every state, the District of Columbia, and Puerto Rico operates a guaranty association funded by assessments on other licensed insurers.7NOLHGA. How You’re Protected Coverage limits vary, but $250,000 in present value is the most common cap. Coverage is provided by the association in your state of residence at the time the insurer is placed into liquidation.
Since 2020, the National Association of Insurance Commissioners has maintained a model regulation requiring anyone recommending an annuity to act in your best interest. Under that standard, agents and insurance companies cannot place their own financial interest ahead of yours, and they must exercise reasonable diligence in evaluating whether a product suits your situation.8NAIC. Annuity Suitability and Best Interest Standard Most states have adopted some version of the rule. If an agent is steering you toward a product that doesn’t fit your financial needs or risk tolerance, you have grounds to push back or file a complaint with your state insurance department.