Annuity

What Is an Annuity?

An annuity is a contract, usually issued by an insurance company, in which the buyer pays money up front or over time, and the insurer agrees to make regular payments back later. The payments may last for a fixed number of years or for the rest of the buyer's life. Annuities are most often used to create retirement income that does not depend entirely on how long savings last.

How Annuities Work

Most annuities have two phases. During the accumulation phase, the contract value grows, either at a set interest rate or based on the performance of underlying investments. During the payout phase, the owner receives income. An immediate annuity begins paying shortly after a lump-sum purchase, while a deferred annuity delays payments for years.

Annuities are generally grouped by how their growth is determined:

• Fixed annuities pay a guaranteed interest rate set by the insurer.
• Variable annuities let the owner choose investment options, so value and income can rise or fall with markets.
• Indexed annuities link growth to a market index, usually subject to caps or participation limits.

Growth inside an annuity typically benefits from tax-deferred growth, meaning earnings are not taxed until withdrawn. Withdrawals of earnings are generally taxed as ordinary income rather than at capital gains rates, and early withdrawals may also face an additional tax penalty.

Costs and Trade-Offs

Annuities can carry significant costs. Contracts may include insurance and administrative charges, fees for optional riders, and surrender charges that apply if money is withdrawn during the early years of the contract. Because terms vary widely, comparing contracts carefully is important. Guarantees are also only as reliable as the financial strength of the insurer behind them.

Annuities are complex products, and their suitability depends on individual circumstances, including how long money will be held and how it fits with other savings. The concept of present value helps in understanding what a future stream of payments is worth today.