The ABCs of Annuities: Types, Benefits, Risks, and How They Work
An annuity is a contract between an individual and an insurance company: you pay a premium (as a lump sum or over time), and the insurer agrees to make periodic payments back to you — either immediately or at a future date. According to LIMRA, total U.S. annuity sales reached $432.4 billion in 2024, a record high, reflecting growing demand for contractual retirement income. This guide explains how annuities work, the main types, common fees, key risks, and how they fit into a retirement plan.
Key Takeaways
- An annuity is an insurance contract — not a bank product. Annuities are not FDIC insured and are not guaranteed by any federal government agency.
- All annuity guarantees depend on the claims-paying ability of the issuing insurance company.
- The main types are fixed, variable, fixed-indexed, immediate, and deferred — each with different risk levels, fee structures, and income features.
- Common costs include surrender charges, mortality and expense fees (variable annuities), and optional rider fees. Rates, charges, and terms vary by carrier and state.
- Annuities may be appropriate for some retirees, but they are not suitable for everyone. Consult a licensed insurance professional before purchasing.
How Do Annuities Work?
At the most basic level, an annuity transfers longevity risk — the risk of outliving your savings — from you to an insurance company. You pay a premium. The insurer invests that premium, manages the risk pool, and in return contractually promises periodic payments under terms defined in the contract.
Annuity contracts involve two phases:
Accumulation phase The period during which your premium earns interest or investment returns before income payments begin. In a deferred annuity, this phase can last years or decades. Earnings grow tax-deferred, meaning no income tax is due until funds are withdrawn. Distribution phase (annuitization) The period when the insurer begins making income payments to you. Payments can be structured for a fixed number of years, for your lifetime, or for the joint lifetime of you and a spouse. Payment structures and options vary by carrier and state.
The word "annuity" comes from the Latin annua, meaning yearly payments. The concept dates to ancient Rome, where soldiers and public officials received lifetime stipends. Modern annuities are regulated insurance products issued by companies licensed in each state where they operate.
What Are the Main Types of Annuities?
Annuities are classified along two dimensions: how they grow (the crediting method) and when payments begin (the timing). The table below summarizes the five major types.
Type: Fixed | Growth Method: Declared interest rate set by insurer | Risk Level: Low (insurer credit risk) | Regulated As: Insurance product | Best Known For: Predictable growth, principal protection
Type: Variable | Growth Method: Investment sub-accounts (stocks, bonds) | Risk Level: Higher (market risk; possible loss of principal) | Regulated As: Securities (FINRA/SEC) | Best Known For: Growth potential with optional guarantees
Type: Fixed-Indexed | Growth Method: Linked to market index, subject to caps and floors | Risk Level: Moderate (no direct market loss; capped upside) | Regulated As: Insurance product | Best Known For: Index-linked growth with downside protection
Type: Immediate (SPIA) | Growth Method: Lump-sum premium converted to income stream | Risk Level: Low (insurer credit risk) | Regulated As: Insurance product | Best Known For: Income that begins within 12 months
Type: Deferred | Growth Method: Varies (fixed, variable, or indexed) | Risk Level: Varies by sub-type | Regulated As: Varies by sub-type | Best Known For: Tax-deferred growth before income begins
Fixed Annuities: How They Work
A fixed annuity credits interest at a rate declared by the insurance company. The rate is typically set for an initial period (one to ten years) and may be adjusted at renewal, subject to a contractual minimum. Your principal is protected from market loss under the terms of the contract.
A common sub-type is the multi-year guaranteed annuity (MYGA), which locks in a fixed rate for a specified number of years — similar in concept to a bank certificate of deposit (CD), but issued by an insurance company rather than a bank. MYGAs are not FDIC insured.
Considerations
Fixed annuities offer predictability, but the declared rate may not keep pace with inflation over long periods, which can erode purchasing power. Surrender charges apply if you withdraw more than the contract's free-withdrawal provision during the surrender period. Interest rates, surrender schedules, and contract features vary by carrier and state of issue.
Variable Annuities: How They Work
A variable annuity allows the contract holder to allocate premiums among a menu of investment sub-accounts — typically mutual fund-like portfolios of stocks, bonds, or money market instruments. Returns depend on the performance of those sub-accounts, which means the contract value can increase or decrease.
Variable annuities are securities products regulated by the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC). They must be sold with a prospectus — a legal document that discloses the annuity's fees, investment options, risks, and terms. You should read the prospectus carefully before investing.
Considerations
Variable annuities carry market risk, including the possible loss of principal. They also tend to have higher fees than fixed annuities, including mortality and expense (M&E) charges, sub-account management fees, and optional rider fees. Some variable annuities offer optional guaranteed minimum income or death benefit riders, but these add cost and their guarantees are subject to the claims-paying ability of the issuing insurer. Features, fees, and sub-account options vary by carrier and state.
Fixed-Indexed Annuities: How They Work
A fixed-indexed annuity (FIA) credits interest based on the performance of an external market index — such as the S&P 500 — subject to a cap rate, participation rate, or spread set by the insurer. If the index declines, the contract credits zero interest for that period rather than a loss, providing downside protection for the principal.
Considerations
The trade-off for downside protection is limited upside: cap rates and participation rates mean you will not receive the full return of the index. These rates are set by the insurer and can be adjusted at renewal. FIAs do not involve direct investment in the stock market and are regulated as insurance products, not securities. However, certain FIAs with enhanced features may be registered as securities. Contract terms, crediting methods, and caps vary by carrier and state.
Immediate Annuities: How They Work
An immediate annuity, also called a single premium immediate annuity (SPIA), converts a lump-sum premium into an income stream that begins within 12 months of purchase. You choose a payout option — life only, joint life, period certain, or a combination — and the insurer calculates the payment based on the premium amount, your age, current interest rates, and the payout structure selected.
Considerations
Once annuitized, the premium is typically irrevocable — you cannot withdraw the lump sum. If you select a "life only" payout, payments stop at your death with no residual value to heirs (other payout options can provide a death benefit, but usually at a lower monthly payment). Immediate annuities address longevity risk directly but sacrifice liquidity. Payout rates, options, and terms vary by carrier and state.
Deferred Annuities: How They Work
A deferred annuity delays income payments to a future date, allowing the premium to grow during an accumulation phase. Deferred annuities can be fixed, variable, or indexed — the "deferred" label refers only to timing, not the crediting method.
A newer variation is the deferred income annuity (DIA) or qualified longevity annuity contract (QLAC), which begins payments at an advanced age (often 80 or 85) in exchange for a lower premium. QLACs, when held in a qualified retirement account, can help defer required minimum distributions (RMDs) up to limits set by the IRS.
Considerations
Deferred annuities provide tax-deferred growth, but surrender charges apply if funds are withdrawn during the surrender period. Most contracts allow annual penalty-free withdrawals of up to 10% of the contract value, but this amount and period vary by contract and state. A deferred annuity commits capital for a longer period than an immediate annuity, which may not be suitable for individuals who need near-term liquidity.
Qualified vs. Non-Qualified Annuities: What Is the Difference?
The tax treatment of an annuity depends on how it is funded:
Qualified annuity Funded with pre-tax dollars, typically inside an IRA, 401(k), or other tax-advantaged retirement account. Contributions may be tax-deductible. The entire withdrawal amount is taxed as ordinary income. Qualified annuities are subject to RMD rules after age 73 (as of 2023 SECURE 2.0 provisions; thresholds are subject to legislative change). Non-qualified annuity Funded with after-tax dollars — money that has already been taxed. Only the earnings portion of each withdrawal is taxed as ordinary income, calculated using the IRS exclusion ratio. Non-qualified annuities are not subject to RMD rules.
In both cases, withdrawals taken before age 59½ may be subject to a 10% IRS early withdrawal penalty in addition to ordinary income tax. A 1035 exchange allows you to transfer funds from one annuity to another without triggering a taxable event, subject to IRS rules.
Tax rules governing annuities are complex and subject to change. Consult a qualified tax professional before making decisions about annuity purchases, withdrawals, or exchanges.
Common Annuity Fees and Charges
Annuity costs vary widely by product type. Understanding the fee structure is essential to evaluating any annuity contract. Actual fees vary by carrier, product, and state of issue.
Fee Type: Surrender charge | Typical Range: 5%–10% (yr 1), declining over 3–10 yrs | Applies To: All deferred annuities | What It Covers: Penalty for early withdrawal beyond free-withdrawal provision
Fee Type: Mortality & expense (M&E) | Typical Range: 1.0%–1.5% annually | Applies To: Variable annuities | What It Covers: Insurance risk, death benefit guarantee, admin costs
Fee Type: Sub-account management | Typical Range: 0.25%–1.0% annually | Applies To: Variable annuities | What It Covers: Investment management of underlying fund portfolios
Fee Type: Rider fees | Typical Range: 0.5%–1.5% annually | Applies To: Annuities with optional riders | What It Covers: Guaranteed income, enhanced death benefit, or LTC riders
Fee Type: Administrative / contract | Typical Range: $0–$50 annually | Applies To: Varies by carrier | What It Covers: Record-keeping and contract maintenance
Fixed annuities (including MYGAs) typically have the simplest fee structures — often limited to surrender charges with no annual asset-based fees. Variable annuities tend to carry the highest total annual costs due to layered charges for insurance, investment management, and optional riders.
What Risks Should You Consider?
No financial product is risk-free. Before purchasing an annuity, consider the following risks:
Insurer credit risk All annuity guarantees depend on the financial strength and claims-paying ability of the issuing insurance company. If the insurer becomes insolvent, contractual guarantees may be impaired. Before purchasing, review the insurer's financial strength ratings from independent agencies such as A.M. Best, S&P Global, Moody's, or Fitch. Liquidity risk Annuities are designed as long-term contracts. Surrender charges may apply for withdrawals beyond the free-withdrawal provision during the surrender period. Immediate annuities are typically irrevocable once payments begin. Inflation risk Fixed annuity payments that do not adjust for inflation may lose purchasing power over time. A payment of $2,000 per month today will buy less in 20 years if inflation averages 3% annually. Some annuities offer inflation-adjustment riders, though these typically reduce the initial payment or add cost. Market risk (variable annuities only) Variable annuity sub-accounts are subject to market fluctuations. The contract value can decrease, and you could lose principal. Past performance of sub-accounts does not guarantee future results. Opportunity cost Funds committed to an annuity may earn less than alternative investments, particularly during periods of strong equity market performance. The trade-off is contractual certainty versus market-dependent returns. Tax penalty risk Withdrawals before age 59½ may incur a 10% IRS early withdrawal penalty in addition to ordinary income tax on the taxable portion.
Lifetime Income Riders and Optional Benefits
Many deferred annuities offer optional riders — contract add-ons that provide additional benefits for an extra fee. The most common is the guaranteed lifetime withdrawal benefit (GLWB), also called a lifetime income rider.
How Lifetime Income Riders Work
A GLWB rider establishes a separate benefit base — a calculated value used solely to determine the income payment. The benefit base may grow through annual roll-up credits or step-ups, even if the contract's actual account value does not increase by the same amount. When you activate the rider, you receive a contractually defined withdrawal percentage (typically 4%–6%, depending on age at activation) applied to the benefit base, payable for life.
The benefit base is not a cash value — it cannot be withdrawn as a lump sum. If you surrender the contract, you receive the actual account value (minus any applicable surrender charges), not the benefit base.
Considerations
Rider fees (typically 0.5%–1.5% per year, deducted from the account value) reduce the contract's accumulation over time. Riders have specific activation rules, withdrawal limits, and conditions that vary by carrier and product. All rider guarantees are subject to the claims-paying ability of the issuing insurance company. Read the rider's disclosure documents carefully and consult a licensed insurance professional to understand how a specific rider works before purchasing.
Annuities and Estate Planning
Annuities allow the owner to name a beneficiary who receives the remaining contract value (or a death benefit, if applicable) upon the owner's death. This transfer bypasses probate in most states, which can simplify estate settlement.
Key Considerations
Beneficiaries of non-qualified annuities owe ordinary income tax on the earnings portion of the death benefit — there is no step-up in cost basis as there is for many other inherited assets. For qualified annuities, the entire distribution is taxable as ordinary income to the beneficiary. Under the SECURE Act (2019) and SECURE 2.0 Act (2022), most non-spouse beneficiaries must distribute inherited retirement account assets (including qualified annuities) within 10 years.
Estate planning with annuities involves complex tax and legal considerations. Consult an estate planning attorney and a qualified tax professional for guidance specific to your situation.
Is an Annuity Appropriate for Your Situation?
Annuities can serve a specific role in a retirement plan, but they are not suitable for everyone. The table below provides general educational guidance — it is not a suitability determination, which can only be made by a licensed professional who understands your individual financial situation, goals, and risk tolerance.
Factors That May Align With Annuity Features: Seeking contractual income that cannot be outlived* | Factors That May Not Align: Needing full access to savings at all times
Factors That May Align With Annuity Features: Have maximized 401(k), IRA, and other tax-advantaged accounts | Factors That May Not Align: Limited savings that cannot be committed for several years
Factors That May Align With Annuity Features: Concerned about longevity risk (outliving savings) | Factors That May Not Align: In poor health with a shortened life expectancy
Factors That May Align With Annuity Features: Want tax-deferred growth beyond other account limits | Factors That May Not Align: In a very low tax bracket with little benefit from tax deferral
Factors That May Align With Annuity Features: Prefer contractual certainty over market-dependent withdrawals | Factors That May Not Align: Uncomfortable with surrender periods and reduced liquidity
Important Disclosures
This article is for educational and informational purposes only and does not constitute financial, investment, tax, or legal advice. Annuity products vary by insurance carrier, state of issue, and individual circumstances. Past performance does not guarantee future results. Please consult a licensed financial advisor, tax professional, or attorney before making any financial decisions.
Annuities are insurance products issued by insurance companies. They are not FDIC insured, are not bank deposits, are not obligations of or guaranteed by any depository institution, and are not guaranteed by any federal government agency. All guarantees and benefits referenced in this article are subject to the claims-paying ability of the issuing insurance company.
Variable annuities are securities regulated by the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC). Investing in a variable annuity involves risk, including the possible loss of principal.
Annuity interest rates, payout rates, and contract terms are set by individual insurance carriers and are subject to change without notice. Rates cited in this article are for illustrative purposes only and may not be available in all states. Contact a licensed insurance agent for current product availability and rate quotes.
Tax information provided is general in nature and based on Annuity.com's understanding of current tax law as of the date of publication. Tax laws are subject to change. Consult a qualified tax professional regarding your specific tax situation.
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