An annuity is a contract with an insurance company in which you agree to pay the insurance company an amount of money (a “premium”), and they agree to make payments to you of a specified amount, with a specified frequency, for a specified period of time. Annuities are designed to transfer longevity risk to an insurer.

There are two basic types of annuities:

  • Immediate annuity – With an immediate annuity you begin to receive payments soon after you make your initial investment. This is generally for retirees that need immediate income from their annuity. When you purchase an immediate annuity you can choose between payments for a certain period of time (“period certain”), payments for the rest of your life and/or your spouse’s life, or any combination of the two.
  • Deferred annuity – With a deferred annuity there is a delay between the time at which you pay the premium (accumulation phase) and the time at which the insurance company begins to send you checks (distribution phase). Your money is invested during that time. With a deferred annuity you can invest either a lump sum all at once, or make periodic payments.

Both immediate and deferred annuities can also be either fixed or variable depending on whether the payout is a fixed sum, or tied to the performance of the overall market or group of investments.

  • Fixed annuities – Fixed annuities pay a fixed amount over the life of the annuity. They pay the annuitant – the person who owns the annuity – a fixed amount of income paid at regular intervals until a specified period has ended or something negative happens to the annuitant, such as sickness or early death. The amount of the monthly payments also depends on the life expectancy of the annuitant: The lower the life expectancy, the higher the payment (because more of the annuity investment must be paid out over a shorter period). They are invested primarily in government securities and high-grade corporate bonds. Fixed annuities are most commonly used by people who are about to retire or have retired.
  • Variable annuities – Variable annuities enable you to invest in accounts that are tied to market performance. Available choices range from the most conservative, such as money market, guaranteed fixed accounts, and government bond funds, to more aggressive stock mutual funds. For a slightly higher annual fee, some variable annuities offer a Guaranteed Lifetime Withdrawal Benefit (GLWB) rider. With the GLWB, the insurance company guarantees a regular monthly, quarterly, or annual payment for your lifetime, even if your account balance goes to zero.

Annuity payouts

Some annuities will allow you to withdraw a portion of your investment or the earnings each year. Withdrawals from an annuity may be subject to taxes and a 10% federal penalty if taken prior to 59 years of age. Most deferred annuities also have a surrender charge – a penalty for making an early withdrawal. Typically this surrender charge decreases over a seven-year period. When you retire and decide to annuitize (guaranteeing income for life), you have several options:

  • Straight Life – a straight life annuity is the simplest form of life annuity – the insurance component is based on nothing but providing income until death. The annuity pays a set amount per period to the annuitant until he/she passes away. Because there is no other type of insurance component of this type of annuity, it is less expensive. Straight life annuities offer no form of payout to surviving beneficiaries after the annuitant’s death. The insurance company keeps any remaining investments.
  • Period Certain – a period certain annuity offers more of an insurance component than a straight life annuity by allowing the annuitant to designate a beneficiary. If the annuitant passes away before the designated term has passed, the beneficiary will receive the sum of the money not paid out. So in the event of an earlier-than-expected death, annuitants do not forfeit their annuity savings to an insurance company. Of course, this comes at an additional cost, and usually a lower monthly payout.
  • Joint Life and Survivor – a joint life and survivor annuity continues payments to the annuitant’s spouse after the annuitant’s death. These annuities also provide the annuitant the chance to designate additional beneficiaries to receive payments if they don’t have a spouse, or in the event of the spouse’s sooner-than-expected death.

Taxation of annuities

One of the advantages of purchasing an annuity is the benefit of tax deferral. None of the money invested in an annuity is taxed until it is withdrawn. If you use pretax money from an IRA or 401k to purchase the annuity, then all withdrawals and distributions will be taxed at ordinary income tax rates. If you use after-tax money to buy the annuity, then a portion of every payout represents a return of your original investment, and the rest is considered taxable earnings.

Investments made after August 13, 1982, are taxed on a last-in, first-out basis. That means for income tax purposes the first money out of the annuity will be considered as earnings, not principal, and will be taxed as ordinary income when withdrawn from the contract. Additionally, just like a traditional IRA, withdrawals made prior to the annuitant’s age 59 1/2 are subject to a 10% early withdrawal penalty.