What’s An Annuity And How Does It Work?

You have many different options when saving for retirement, including IRAs, 401k accounts, brokerage accounts, real estate and more. As you make a plan for saving and investing money, it's smart to consider all of the different options. An annuity can be one option to help you save for retirement, especially if you are concerned about longevity and possibly outliving your money.

What’s An Annuity?

An annuity is an insurance product that you purchase either with a lump sum payment or in a series of payments. Then, the insurance company pays you either immediately or in the future, whenever you need the money.

Getting An Annuity

As our guide to financial services explains, you should shop around when you buy an annuity, just like you would with any insurance product, because the payout amounts and options will vary. Getting quotes from several different providers will help ensure that you buy the one that best fits your specific situation. You may also want to consider buying annuities from more than one company, depending on your state’s guaranty association limits.

Another thing to check is whether the annuities are financially secure. Make sure they have an “A” rating or better from insurance raters like Moody’s, A.M. Best, Fitch, or Standard & Poor’s. Once you decide to purchase an annuity, you will be able to make a lump-sum payment or monthly installment payments. Keep in mind that how you choose to purchase and pay for your annuity can affect how your annuity is paid out.

How Annuities Work

One way to think of an annuity is turning either a lump-sum payment or multiple payments into regular annual income either immediately or in the future. The words annuity and annual (meaning every year) share the same root word, because a typical annuity will make regular payments every year.

While the root concept of an annuity may be simple to explain, there are several nuances that you'll want to be aware of:

Annuity Phases

Most annuities have two different phases, and each one can last several years.

Accumulation Phase

The accumulation phase of an annuity is when you are making payments and building up the cash value of the annuity. Usually, this is the first phase of an annuity, though it's possible that an annuity will not have an accumulation phase, for example if you just make one lump sum payment to start the annuity. Once the accumulation phase is over, you flow into the annuitization phase.

Annuitization Phase

The annuitization phase of the annuity is when all the money you invested turns into periodic income payments. There are many options for how you can choose to have the money in your annuity paid out — you can choose to have the payments annuitized (converted into payments) for a set number of years or for as long as you live. Many annuities also have options that allow you to make payments to your beneficiaries once you pass away.

Annuity Payouts

Annuities can be either immediate or reserved for several years in the future. Each type of annuity payout comes with its own pros and cons.

Immediate Annuities

An immediate annuity will start paying out 30 days to 1 year after purchase. These will be best to buy when you are close to retirement or during your retirement.  With an immediate annuity, there is generally no accumulation phase, since it begins paying out immediately.

Deferred Annuities

A deferred annuity will pay out at a later time, specified by the terms and conditions in your annuity contract. Generally, you will contribute money into the annuity for several years. After a certain amount of time, the annuity will start to pay out. As you start calculating how much money you need in retirement, consider how an immediate or deferred annuity might fit into your retirement plans.

Types Of Annuities

Annuities can come in different forms that are designed to work in slightly different ways. Understanding the different types of annuities can help you decide which one might be best for your specific situation. The type of annuity you choose will determine the rate of return you receive when you start to take disbursements. Here's a look at some of the most common types of annuities:

Fixed Annuities

A fixed annuity pays out a guaranteed amount each month or year. While it might sound good to have a guaranteed amount of money coming in, the tradeoff is that fixed annuities often have relatively low annual returns, usually only a bit higher than a CD. One way to think of a fixed annuity is as a savings account with an insurance company.

Variable Annuities

With a variable annuity, you have the ability to potentially receive a higher return on your money. In a variable account, you can pick from a list of mutual funds. Your retirement payouts will be based on the performance of these investments.

Indexed Annuities

An indexed annuity can be a middle ground in regard to risk and reward. With an indexed annuity, you are guaranteed a minimum payout, with a portion of your return tied to the performance of a market index, like the S&P 500.

Tax Implications Of Annuities

While you are in the accumulation phase of an annuity, your gains are not subject to income tax. Once you enter the annuitization phase, the money you are paid from your annuity is generally subject to income tax. Another thing to keep in mind is that many annuities have the option to receive a lump-sum cash payment. In that case, you do not have to pay taxes on the amount that you have contributed (your basis), but you will owe capital gains taxes on any investment gains you've received.

Annuity Pros And Cons

Annuities are some of the more complicated forms of investments, and purchasing an annuity comes with various benefits and potential downsides. Understanding the advantages and disadvantages of annuities will help you decide whether an annuity is the right choice for you. We also encourage you to work with a licensed financial planner to create a retirement plan that’s right for you.

Advantages Of Annuities

• Provide for a beneficiary: Depending on the type of annuity you purchase, there may be money associated with the annuity that can be received by a beneficiary. When you pass away, these remaining payouts can start going to your beneficiary.
• Unlimited contributions: Annuities generally don’t have yearly contribution limits or maximums. This gives you the ability to put away as much as you want and defer paying taxes on it. 
• Make savings last: The longer we live, the longer our money needs to be available to us as well. Many annuities are structured to provide a guaranteed stream of income, no matter how long you live.
• Tax Deferrals: Earnings on annuities are tax-deferred. This means you won't pay taxes on your investment gains as long as you don’t take withdrawals on your money. This is a useful advantage of an annuity if you expect to be in a lower tax bracket when you retire.

Disadvantages Of Annuities

• Difficulty accessing funds: Once your terms have been set, it might be too expensive to take out any funds, or, depending on your contract, you might not be able to access the funds. You’ll find it especially hard to get them once your distribution is set or starts paying out.
• Charges and fees: The biggest downside of an annuity is that there can be significant charges and fees associated with the product. This can include the management fee, surrender charges, and mortality and expense risk fee. All of these fees and charges can really eat into your return, making an annuity much less attractive than other types of investments.
• Tax on payouts: The most significant downside to an annuity is the fact that you are going to be taxed when you start receiving payouts. The amount of tax is going to depend on your current income tax rate.

Annuity FAQs

How much does a $100,000 annuity pay per month?

It is impossible to answer with certainty how much a given annuity will pay per month. This is because the amount that annuities pay varies wildly depending on factors including the age and gender of the purchaser, the type of annuity, etc. As a very rough ballpark, you might expect a $100,000 annuity for a 65-year-old woman in Michigan to pay $500 – $700 per month for the rest of her lifetime. This amount could change based on any number of factors.

Is an annuity a good investment?

Whether an annuity is a good investment will depend on your own specific situation. Proponents of annuities point to the fact that it is guaranteed income for the rest of your life. Annuity detractors mention the high fees and lower rates of return of annuities. Because annuities often pay high commissions to insurance agents and financial advisors, they are sometimes promoted even when it's not the right situation.

Can annuities lose value?

Yes, it is possible for annuities to lose value, depending on the type of annuity that you have purchased. This typically happens during the accumulation phase, where you are putting money into growing your annuity. Once an annuity starts paying out, it typically is setup so that it provides the same guaranteed payment each month or year.

Who should buy annuities?

Figuring out if an annuity is right for you will come down to your specific financial situation and your age. Someone that is currently in a high tax bracket, worried about outliving their savings or thinks that they might live longer than average might consider purchasing an annuity. An annuity can also be a good addition to someone who has several other types of retirement savings as well.

Who should avoid buying annuities?

If you are someone who has a pension or thinks that your Social Security benefits will cover the majority of your living expenses, you may want to avoid an annuity. If you have health problems, or for any other reason think you might not live as long as the national average, that's another reason to avoid an annuity. And if you have even a little bit of experience and confidence in investing on your own, you may find that you will be better off with your own investment plan than by purchasing an annuity.

The Bottom Line

Annuities can work in some situations, but for many people, saving or investing in other forms will be a better long-term strategy. Because of the high commissions paid to advisors that sell annuities, they are often promoted even in situations where they might not be a great fit. Before deciding on an annuity, consider other ways to save for retirement because it could save you time and money. 

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