How do annuities work?

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Many people know about 401(k)s and IRAs, but there are many other options for retirement planning and wealth-building. Find out more about annuities and whether this option might be right for you.

What is an annuity?

Annuities are a type of insurance product, but instead of insuring yourself or your property against potential future losses, annuities let you insure income. Specifically, they help ensure that you will receive an agreed-upon amount of money periodically at some point in the future, which makes them a popular vehicle for retirement planning.

How annuities work

The basic concept behind annuities is that you purchase a product now. You pay for it either in a lump sum or via agreed-upon payments—sometimes in the form of insurance premiums over a period of years.

In exchange, at some point in the future, you begin to receive payments on your annuity. Those payments typically come periodically, such as monthly, quarterly or annually. Depending on the annuity product you purchase, you can receive those payments for a certain period of time or for the rest of your life once the annuity payout begins.

You can generally expect to get back more in annuity payments than you pay into the product. That’s why they’re considered an investment. The reason for this is that your annuity purchase price or premium payments are put into a pot with all the other payments being made by annuity customers for that product or provider. Those funds are invested, and the earnings over time result in a profit for you and the insurance provider.

The main types of annuities

How much you can earn, when and how it pays out and the risk associated with your investment all depend on what type of annuity you buy. The types of annuities are summarized below to help you determine if any might be a good choice for you.

Deferred annuities versus immediate annuities

The first major decision to make when purchasing an annuity is whether you want a deferred or immediate annuity. Deferred annuities begin paying out at some agreed-upon point in the future, making them potential vehicles for retirement planning. Immediate annuities start paying out immediately, which might make them a better option if you’re close to retirement or want to ensure a certain level of income in the near future.

Three categories of annuities

Once you decide when you want your payouts to begin, you’ll need to pick a more specific type of annuity to invest in. Both immediate and deferred annuities have three major categories which are outlined below.

1. Fixed annuities

Fixed annuities are those that pay out an agreed-upon, guaranteed amount each time you receive income. This can be a good option if you want a stable income you can count on. The downside of fixed annuities is that the lower risk comes with lower potential reward from a returns perspective.

2. Fixed indexed annuities

Fixed indexed annuities guarantee at least a minimum amount paid out, so they can help provide stability for your budget. But part of your returns is tied to the performance of a market index. Market indexes include options such as the Dow Jones or S&P 500. If you have a fixed indexed annuity, then you might earn more payout than the minimum if the market performs well in a given period.

3. Variable annuities

Variable annuities are tied to a group of mutual funds. The amount of your annuity payouts depends on the performance of those funds. That can mean greater long-term reward, but it also comes with more risk than either of the other two categories of annuities.

Can you withdraw your money early?

You may be able to withdraw money from an annuity early if you find that you need your investment back or can’t wait until payouts are scheduled to begin. But this can be a costly move.

First, if you take money out of a retirement account, including some annuities, before reaching retirement age, the IRS may levy a 10% penalty. You’ll also have to pay any applicable taxes on the income.

For the purposes of annuities, penalties and taxes are only paid on the amount you earned on the investment. You’re not taxed on the amount you paid into the annuity because you were already taxed on that amount when you earned it the first time.

In some cases, the IRS waives the 10% penalty. Such cases include the total disability of the annuity owner or the annuity owner taking early withdrawals to pay for qualified education expenses.

How are annuities taxed?

Taxes on annuities can be complex, so it’s important to consult a tax professional to understand what your tax burden might be. Typically, payments you make toward an annuity are not made with pre-tax dollars. That means the money you pay into an annuity is already taxed, and you won’t pay income tax on it again in the future.

But you might owe taxes on any earnings you make from the investment. That means when you begin to receive payouts, you will have to report the income and calculate how much of it is taxable.

Is an annuity right for you?

Deciding whether any investment is right for you is an individual matter. You must look at your current financial state, your goals for the future and the level of risk you’re comfortable with. Since annuities are based on contracts, they’re typically considered less risky than stock market investments, but no investment is 100% guaranteed. Consider talking to a financial adviser to understand what investment and retirement planning options might be right for you.

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