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Annuities can offer security in retirement. Here’s how they work.

What is an annuity?

An annuity is a periodic payment of a sum of money to an individual over time. Usually the length of time extends over the lifetime of the individual receiving the annuity. It sometimes even transfers to the heirs of an estate in the event of death. Overall, many investors consider annuities a safer investment over stocks and mutual funds, as they come with some guarantees.

Deeper definition

Most often, an annuity is an insurance product that pays income at some point, typically at retirement. People can accumulate funds in an annuity account during their career and begin receiving a stream of income when they retire. Or they can purchase an annuity in one transaction with a lump sum payment. Some are called longevity annuities and don’t pay out until as late as age 85. They can be used as payment for long-term care. Other annuities have a life insurance feature that pays a benefit in the event of premature death.

You should consider investing in an annuity only after maxing out other retirement investment accounts, such as a 401(k) plan and an individual retirement account. Once you have invested the maximum amount in these types of accounts, if you still have money left over to invest, then consider investing in an annuity account. While any growth from an investment in an annuity is tax-deferred, once you start withdrawing from the account, the earnings are taxed as ordinary income.

Before investing in an annuity, review any charges and fees associated with management of the annuity. Look out for any costly early withdrawal fees. To avoid these fees, you should only invest in an annuity if you plan on keeping your money in the account for the long haul. If you do plan on withdrawing from the annuity at some point in the future, make sure you know the time duration you must wait to do so without a incurring a big penalty.

Annuity examples

There are different types of annuities:

  • Immediate annuities are purchased with a lump sum amount and begin payments soon after purchase.
  • Deferred annuities accumulate and are converted into an income stream at a later time, typically years later.
  • There are fixed annuities, variable annuities and equity-indexed annuities. Read on to learn more about annuities.

When initially investing in an annuity, the insurance company invests your annuity payments. The company gets to keep any of your investment above a given amount guaranteed to you. The insurance company also makes money on any fees you pay for it to manage the annuity.

At a certain point, your annuity starts to pay out at a specific pre-determined amount. The payments come every month, quarter or year as determined between you and the insurer. Some annuities allow you to receive a lump-sum payment.

Fixed annuities

A fixed annuity uses a set interest rate determined at time of purchase and payments stay the same over the lifetime of the contract. A fixed annuity provides plan owners protection from interest rate fluctuations in the market. However, the fixed annuity does not account for inflation, which can reduce the value of payments over time.

Variable annuities

A variable annuity invests in various subaccounts, consisting of stocks, bonds and money market funds. This gives investors the opportunity to earn a higher return on investment and potentially gives them a higher payout upon retirement. It’s not without risk, however, because if the investment declines, so does the payout.

Equity-indexed annuities

Equity-indexed annuities are a cross between fixed and variable annuities, offering the best of both. Like a fixed annuity, you receive a guaranteed minimum return, but you also can gain higher returns as with the variable annuity. Some of the downsides of an equity-indexed annuity include high surrender fees, as high as 20 percent, and a lower return than the index it’s tied to. Because these annuities are complex, they are difficult for investors to fully understand.

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