What is an annuity? Understand types, benefits and how they work

After you retire, you'll need a plan to cover your living expenses and maintain the lifestyle you've worked hard to build. Social Security can provide one stream of income. A pension plan can add another, if you have access to one. But many retirees want more certainty, and that's where an annuity can help.

Annuity accounts can complement other retirement income vehicles, such as IRAs and 401(k)s, and may provide guaranteed income through retirement.

This guide breaks down what an annuity is, how annuities work, the main types available, how they're taxed, and how to determine whether an annuity fits your retirement plan.

What is an annuity?

An annuity is a contract between you and an insurance company. You contribute money, and the company promises to pay you back as regular income, either immediately or on a schedule you choose.

Think of it as a way to turn savings into a more predictable paycheck. Much like a pension, an annuity can deliver dependable income throughout retirement. That predictability is one reason retirees consider annuities as part of an income plan.

Bottom line: An annuity is an insurance product designed to provide guaranteed income, giving you one more reliable source to count on.

How do annuities work?

Annuities typically work in two stages: an accumulation phase and a distribution phase.

• Accumulation phase: You contribute money to the annuity, either as a lump sum or through regular payments. Your money grows tax-deferred and you generally don’t pay taxes on the earnings until you begin withdrawals.
• Distribution phase: The annuity begins paying you income. Depending on your contract, payments may be taken as a lump sum, over a set number of years, or for the rest of your life.·

Some annuities start payments soon after purchase. Others are designed to provide income later. This flexibility can help you match the annuity to your retirement timeline.

Annuity example: how it works in practice

Say you're 65 and you use a $100,000 lump sum to buy an immediate fixed annuity. In exchange, the insurance company agrees to pay you a set amount each month for the rest of your life, for example, around $600 a month, or $7,200 a year. Those payments continue no matter how long you live, even if you receive far more than your original $100,000, as long as the insurer can meet its obligations.

That's the appeal. You exchange a lump sum for a stream of income you can plan around. The exact amount depends on your age, the interest rate environment, the type of annuity, the issuing insurance company, and any options you add, such as payments that continue to a spouse.

Bottom line: An annuity converts a portion of savings into predictable income. Actual payment amounts vary by contract and provider.

Why longevity risk makes annuities appealing

One concern sits at the center of retirement planning: outliving your money. Financial professionals call this longevity risk, and it's a common reason retirees consider annuities.

The concern is real. According to the U.S. Bank 2025 Wealth Report, 61% of Americans expect to be retired for more than 15 years, yet only 58% feel confident their savings will last through retirement. That gap between how long retirement may last and how confident people feel is exactly where an annuity can help.

An annuity that pays for life shifts longevity risk to the insurance company. As long as you live, the payments can continue, subject to the terms of your contract and the claims-paying ability of the insurer.

What are the types of annuities?

There are two main types of annuities: fixed and variable. Within those categories, you'll also find fixed indexed, immediate, and deferred income options. Here's how each one works.

What is a fixed annuity?

A fixed annuity pays a guaranteed rate of return for a set period. It's generally more conservative, which may be appealing if you value stability and predictable growth.

Depending on contract terms, fixed annuities may offer principal protection if you hold the annuity through the surrender period. Withdrawals before the end of the surrender period can trigger surrender charges and may reduce the value of the annuity.

A traditional fixed annuity earns a declared interest rate set by the insurance company, much like a certificate of deposit (CD).

What is a fixed indexed annuity?

A fixed indexed annuity offers growth potential based in part on the performance of a market index, such as the S&P 500. It typically offers more upside potential than a traditional fixed annuity, with built-in downside protection so your credited interest won’t fall below zero during a crediting period (subject to contract terms). It may appeal to you if you want growth potential with less market risk.

What is a registered index linked annuity?

A registered index linked annuity (RILA) links its performance to a market index, such as the S&P 500. Unlike a fixed indexed annuity, a RILA may include a buffer or floor to help limit losses but not entirely eliminate risk. In exchange for taking on more risk, it may offer greater growth potential than a fixed indexed annuity.

What is a variable annuity?

A variable annuity invests in market-based subaccounts, similar to mutual funds. That means your returns can rise or fall with the market. Variable annuities offer more growth potential, but they also carry more risk and often come with higher fees.

What are immediate and deferred annuities?

The timing of your payments defines these two options:

• Immediate annuity: Income payments begin within the first 12 months of the contract. This may suit retirees who want income to start right away.
• Deferred annuity: Income begins one year or more in the future, giving your money more time to grow before payments start.

Fixed annuity vs. variable annuity: What’s the difference?

A fixed annuity is an insurance contract that offers a guaranteed rate set by the insurer. A variable annuity is filed with the Securities and Exchange Commission and invests in the market, so its value and returns can change. Here's a side-by-side comparison.

Both types may include insurance guarantees and can be structured to provide lifetime income. Variable annuities may offer optional lifetime income riders for an additional cost.

Bottom line: A fixed annuity may fit if you want more predictability. A variable annuity may fit if you want growth potential and can accept market risk.

How annuities compare to other retirement income sources

An annuity is one piece of the retirement income puzzle. Here's how it stacks up against the sources you may already have.

• Social Security: Provides inflation-adjusted income for life, but it may not cover all your expenses. An annuity may help fill part of the gap.
• Pension: Works much like an annuity, paying steady income in retirement. If you don't have a pension, an annuity can create a similar stream.
• 401(k): A powerful way to save during your working years, often with an employer match. It doesn’t guarantee income, and you decide how and when to take withdrawals.
• IRA: Offers tax-advantaged growth and flexible investment choices, but it doesn’t guarantee lifetime income on its own.

The key difference: 401(k)s and IRAs help you build savings, while an annuity can help you turn savings into reliable income.

Bottom line: Annuities can complement, rather than replace, other retirement accounts by adding a layer of guaranteed income.

How much do annuities cost? Fees and surrender charges

Annuity costs depend on the type you choose.

• Fixed annuities typically don’t have annual investment management fees, but costs and trade-offs may be reflected in the credited rate and contract terms.
• Variable annuities are filed as securities and often include investment charges, plus insurance, mortality, and expense charges. Riders may add fees.

Most annuities also include a surrender period, which is the length of time you must wait before withdrawing funds without a penalty. Take money out early, and you'll typically owe a surrender charge.

Many annuities let you access a percentage of your money each year penalty-free. Some contracts also include provisions for certain situations, such as terminal illness or nursing home care. Once the surrender schedule ends, you can generally access your money without a surrender charge.

One more thing to know: like other retirement accounts, withdrawing before age 59½ may trigger a 10% federal tax penalty on any gains.

How are annuities taxed?

Annuities grow on a tax-deferred basis, similar to a traditional IRA. You generally don't pay taxes on the earnings while your money accumulates. Once you withdraw, you owe taxes on the growth.

When you start taking money out:

• Earnings are generally taxed as ordinary income.
• Withdrawals before age 59½ may face a 10% federal tax penalty on gains.
• For certain non-qualified annuitized contracts, a rule called the exclusion ratio may apply. Part of each payment is a return of your principal, so you're not taxed on that portion.

Because tax rules can be complex and depend on your situation, it's a good idea to consult a tax professional.

How to buy an annuity

Buying an annuity starts with knowing your goal: guaranteed income, tax-deferred growth, principal protection, or a mix. From there, a typical process looks like this:

• Review your retirement income needs and time horizon.
• Compare annuity types, features, fees, and payout options.
• Evaluate the financial strength of the issuing insurance company.
• Choose any optional riders based on your needs.
• Complete an application with the help of a financial advisor or insurance professional.

Annuities can be detailed products with many moving parts. A financial advisor can help you compare options and confirm whether an annuity fits your broader plan.

What are the annuity payout options?

Annuities offer multiple ways to receive your money. Many fixed and variable annuities include provisions called riders, which may allow you to access a guaranteed amount of income each year, regardless of how the annuity performs or what remains in your contract balance.

You'll also find specially designed products called immediate and deferred income annuities:

• Immediate income annuity: Payments begin within the first 12 months of the contract.
• Deferred income annuity: Payments begin one year or more in the future.

These options let you decide when income starts and how long it lasts, including guaranteed income for life.

What are the pros and cons of annuities?

Every financial tool has trade-offs. Here's a clear look at both sides.

Pros of annuities

• Can provide guaranteed income you can plan around in retirement.
• Offer tax-deferred growth on your earnings.
• Fixed annuities may protect your principal, depending on contract terms.
• Some contracts include death benefit provisions for beneficiaries.

·         Can help reduce the risk of outliving savings when structured for lifetime income.

Cons of annuities

• May be less liquid, especially during the surrender period.
• Variable and registered index linked annuities can lose value in a down market.
• Some contracts include fees, especially variable annuities with riders.
• Growth may be capped or limited depending on the annuity type and contract terms.

Bottom line: Annuities can reward long-term planning. If you need quick access to your cash, weigh liquidity and surrender charges carefully.

Are annuities right for you?

Annuities work much like a pension or Social Security. They can provide an income stream and help manage longevity risk. That can make them a fit if your priority is steadier retirement income.

When considering an annuity, start with your goals and the level of protection you want:

• Want a steady, predictable return? A fixed or fixed indexed annuity may be a good choice.
• Comfortable with market risk for more growth potential? A variable annuity may fit.
• Prefer simplicity and predictability? A fixed annuity may align well.

Next steps: Talk to a financial advisor

An annuity can be a useful addition to a retirement plan, but it’s best evaluated in the context of your full financial picture. A tax or financial advisor can review your income needs, weigh tax implications, and help you compare annuity options. They can also help with the application process.

Ready to explore your options? Learn how we can help you design your retirement income strategy.