Annuities are not investments in the traditional sense — they are insurance contracts that trade market growth for may provide income

An annuity does not work like a stock or bond. You give an insurance company a lump sum or make payments over time, and in return, the company promises to pay you a set amount at regular intervals — usually for life or for a fixed period. Whether that trade-off makes sense depends entirely on what you need the money to do and what you are willing to give up to get it.

The core question is not whether annuities are "good" investments. It is whether you want predictable income more than you want growth potential or flexibility. An annuity locks money away. In exchange, it removes the risk that you will outlive your savings or that market downturns will force you to cut spending. For some people, that trade is worth it. For others, it is not.

Key Takeaways

  • Annuities provide may provide income but limit your access to the money and usually offer lower growth than stock-based investments over long periods.
  • A fixed annuity pays the same amount every month regardless of market performance, while a variable annuity's payments depend on how underlying investments perform.
  • Annuities carry high fees — often 1 to 3 percent annually plus surrender charges if you withdraw early — that reduce what you actually receive.
  • Annuities work best for people who have other savings, want to cover essential expenses with may provide income, and do not need access to large sums quickly.
  • You can buy an annuity with money from a 401(k) or IRA, but the decision should be made carefully because you cannot undo it.

How annuity payouts compare to other income sources

A fixed annuity pays you the same dollar amount every month for life (or a set number of years). The insurance company bears the investment risk — if markets crash, your payment stays the same. The trade-off is that your payment does not grow with inflation, so its purchasing power shrinks over time. A payment of $2,000 per month today buys less in 20 years.

A variable annuity ties your payments to the performance of investment accounts you choose within the contract. If those investments grow, your payments can increase. If they decline, your payments can fall. You keep some upside potential but lose the may provide. Variable annuities also carry higher fees because the insurance company is managing investment options.

Compare this to straightforward holding stocks and bonds in a regular brokerage account. You control the money, pay lower fees (often under 0.5 percent annually), and can withdraw whatever you need whenever you need it. But you also bear all the risk. If you spend too much early or markets fall sharply, you might run out of money. An annuity removes that risk — but only if you never need the money back.

The cost of annuities: fees that reduce your actual return

Annuities are expensive. A fixed annuity typically charges 1 to 3 percent annually in administrative and insurance fees, though some charge less. A variable annuity often costs 2 to 3 percent per year or more, because it includes investment management fees on top of the insurance cost. These fees are deducted from your account before you see any payout.

Most annuities also include a surrender period — usually 5 to 10 years — during which you cannot withdraw your money without paying a penalty. The penalty typically starts at 5 to 10 percent of the withdrawal amount and decreases each year. If you need the money before the surrender period ends, you lose a significant chunk to the penalty.

Some annuities offer riders — add-ons that provide extra features like a may provide minimum income or a death benefit. Each rider adds cost. By the time you add up the base fee, the rider fees, and the surrender charge, an annuity can cost you 3 to 5 percent of your money in the first year alone. That is money that never goes toward your income.

When an annuity might make sense for your situation

An annuity works best if you have already saved enough to cover discretionary spending and you want to may provide that essential expenses — housing, food, utilities, healthcare — are covered no matter what happens in the markets. Social Security covers some of this for most people. An annuity can cover the gap.

Annuities also make sense if you have a large lump sum you do not know how to manage — for example, an inheritance or a 401(k) balance at retirement — and you want to convert part of it into income you cannot outlive. This is especially true if you are in your 70s or 80s, because the older you are when you buy an annuity, the higher your monthly payment will be (the insurance company expects to pay you for fewer years).

An annuity is less useful if you are young, have a long time horizon, or think you might need access to the money. It is also less useful if you have already built a diversified portfolio of stocks and bonds that is generating the income you need. In that case, you are paying extra fees for a may provide you do not require.

The irreversibility problem: you cannot change your mind

Once you buy an annuity and the payout period begins, you cannot undo the decision. If you bought a fixed annuity and inflation rises sharply, your payment stays the same and you lose purchasing power. If you bought a variable annuity and the underlying investments perform poorly, your income falls. If you need a large sum for an emergency, you cannot access it without paying a surrender charge.

This is why annuities should only be purchased with money you are certain you will not need for other purposes. If you are considering converting a 401(k) or IRA into an annuity, think carefully about whether you have other savings to fall back on. Many financial advisors recommend annuitizing only a portion of retirement savings — perhaps 25 to 50 percent — to cover essential expenses while keeping the rest in investments you can access.

Annuities inside retirement accounts: the tax angle

You can buy an annuity with money from a 401(k), IRA, or other tax-deferred account. The advantage is that you do not trigger a taxable event when you move the money into the annuity. The disadvantage is that annuities are already tax-deferred accounts, so buying an annuity inside an IRA or 401(k) adds a layer of complexity without a tax benefit.

The real reason to buy an annuity inside a retirement account is to convert a pool of money into may provide income. For example, you might use part of your 401(k) balance to buy an annuity that pays you $2,000 per month starting at age 70, and keep the rest in mutual funds. This is called a may have access to longevity annuity contract (QLAC) when done in an IRA, and it has special rules about how much you can invest and when payments must start.

What happens to your money if you die

With a straightforward annuity, if you die before the payout period ends, the remaining balance stays with the insurance company. Your heirs receive nothing. This is one reason annuities are unpopular with people who want to leave money to their children.

You can add a death benefit rider that guarantees your heirs will receive at least what you paid in, or a set amount, if you die early. But this rider costs extra and reduces your monthly payment. Some annuities offer a "period certain" option — you receive payments for a may provide number of years (say, 20 years), and if you die before that period ends, your heirs receive the remaining payments. Again, this costs more than a straightforward life annuity.

Frequently Asked Questions

Should I buy an annuity instead of keeping money in stocks and bonds?

That depends on whether you want may provide income or growth potential. Stocks and bonds historically return more over long periods, but you bear the risk of market downturns and the risk of running out of money. An annuity guarantees income but costs more in fees and offers lower growth. Most financial advisors suggest using annuities for a portion of retirement savings — enough to cover essential expenses — while keeping the rest in diversified investments.

Can I get my money back if I change my mind about an annuity?

During the surrender period (usually 5 to 10 years), you can withdraw your money, but you will pay a surrender charge that typically ranges from 5 to 10 percent of the withdrawal amount. After the surrender period ends, you can withdraw without penalty, but if you have already started receiving payments, the contract may not allow full withdrawals. Always read the contract terms before buying.

What is the difference between an when ready annuity and a deferred annuity?

An when ready annuity begins paying you within a few months of purchase. A deferred annuity lets your money grow for years before payments start. Deferred annuities are useful if you are not yet retired but want to lock in a may provide income for later. when ready annuities are useful if you need income now and have a lump sum to invest.

Are annuities safe if the insurance company fails?

Insurance companies are regulated by state insurance commissioners, and most states have a guaranty fund that protects annuity holders if an insurer becomes insolvent. The protection limit varies by state but is typically $100,000 to $250,000 per person per company. Before buying an annuity, check your state's guaranty fund limits and the financial strength rating of the insurance company.

Can I use an annuity to reduce my taxes?

An annuity itself does not reduce your taxes — the income you receive is taxable. However, if you buy an annuity with money from a traditional IRA or 401(k), you do not trigger a tax event at the time of purchase. The tax is deferred until you start receiving payments. If you buy an annuity with after-tax money, part of each payment is considered a return of principal and is not taxed, which can provide a small tax advantage.