What happens when you buy an annuity

An annuity is a contract between you and an insurance company. You give the company a lump sum of money (or make payments over time), and in return, the company promises to send you regular payments for a period you choose — either for a set number of years or for the rest of your life. The insurance company invests your money and uses the returns, along with what other customers pay in, to fund those payments back to you.

The basic flow is straightforward: you transfer money to the insurance company, they hold it and invest it, and they send you checks on a schedule you agree to in advance. The amount of each payment depends on how much you put in, how long you want payments to last, your age, and current interest rates at the time you buy.

Key Takeaways

  • You pay a lump sum or series of payments to an insurance company, which then sends you regular income payments based on a schedule you choose.
  • The insurance company invests your money and uses investment returns to fund your payments, so the amount you receive depends partly on how well those investments perform.
  • when ready annuities begin payments within a year of purchase, while deferred annuities delay payments until a future date you select.
  • Fixed annuities may provide a set payment amount, while variable annuities tie payments to investment performance and carry more risk.
  • Once you buy an annuity and payments begin, you typically cannot get your money back in a lump sum, so the decision is largely permanent.

The two main timing structures: when ready and deferred

An when ready annuity starts sending you payments within one year of purchase — usually within a few months. You hand over your money, and the insurance company begins the payout schedule right away. This is common for people who have just retired and need income to start flowing when ready.

A deferred annuity delays payments until a future date you choose, sometimes decades away. During the waiting period, your money grows inside the contract, either at a fixed rate or tied to market performance depending on the type. When the payout date arrives, the insurance company converts your accumulated balance into regular payments. Deferred annuities are often bought by people in their 40s or 50s who want to lock in income for later retirement years.

Fixed annuities versus variable annuities

A fixed annuity guarantees a specific payment amount for the life of the contract. The insurance company absorbs all investment risk — if markets fall, your payment stays the same. In exchange, your growth is capped at whatever rate the insurance company promises, which is typically modest. You know exactly what you will receive each month, which makes budgeting predictable.

A variable annuity ties your payments to the performance of investment accounts you choose — usually mutual funds or similar options. If those investments perform well, your payments can increase. If they perform poorly, your payments can decrease. You carry the investment risk instead of the insurance company. Variable annuities also tend to have higher fees than fixed annuities because the insurance company is managing more complex investments and providing ongoing account administration.

How the insurance company calculates your payment amount

The payment amount depends on several factors working together. The most obvious is how much money you put in — a larger deposit produces larger payments. Your age at the time you buy also matters significantly: the older you are, the higher each payment, because the insurance company expects to pay you for fewer years. Current interest rates affect the calculation too; when rates are higher, your payments are higher because the insurance company can earn more from investing your money.

If you choose a payment option that includes a surviving spouse or beneficiary, your individual payment will be lower, because the insurance company may need to continue payments after you die. If you choose payments for life with no survivor benefit, your payment is higher. The insurance company uses actuarial tables — statistical models based on life expectancy — to set the payment so that the total amount it pays out over your expected lifetime roughly matches what you put in plus investment returns.

What happens to your money during the accumulation phase

If you buy a deferred annuity, there is a period between when you pay and when payments begin — this is called the accumulation phase. Your money sits in the annuity contract and grows. With a fixed deferred annuity, it grows at a may provide rate set by the insurance company. With a variable deferred annuity, it grows based on the performance of the investment options you selected.

During this phase, you typically cannot withdraw your money without penalty. Most annuity contracts include a surrender period — usually 5 to 10 years — during which withdrawals beyond a small annual amount (often 10 percent) trigger a surrender charge. This charge is a percentage of the withdrawal amount and goes to the insurance company. After the surrender period ends, you can usually withdraw without penalty, though you may still owe taxes on any gains.

The payout phase and your payment options

Once the payout phase begins, the insurance company converts your accumulated balance into a stream of payments. You choose the payment structure when you buy the annuity, and this choice is usually permanent. Common options include: payments for your life only (highest individual payment, but stops when you die); payments for your life and a survivor's life (lower individual payment, but continues to a spouse or beneficiary); payments for a set number of years regardless of whether you are alive; or a combination of these.

Payments are typically made monthly, quarterly, or annually — you choose the frequency. The insurance company sends the payment directly to your bank account or by check. If you chose a life annuity, payments continue as long as you live, even if you reach an age far beyond the statistical average. If you chose a term certain annuity (payments for a set number of years), payments stop at the end of that term, even if you are still alive.

Tax treatment of annuity payments

How much of each annuity payment is taxable depends on where the money came from. If you bought the annuity with after-tax money (money you already paid income tax on), part of each payment is a return of your original investment and is not taxed again; the rest is taxable as income. The insurance company calculates an exclusion ratio — the percentage of each payment that represents your original investment — and reports this to you and the IRS.

If you bought the annuity with pre-tax money from a retirement account like a traditional IRA or 401(k), the entire payment is taxable as ordinary income. If you bought it with after-tax money inside a Roth IRA, the payments may be tax-free if certain conditions are met. The tax treatment is set when you buy the annuity and does not change, even if tax laws change later.

Why you cannot easily reverse the decision

Once you buy an annuity and it begins paying, you are locked in. You cannot call the insurance company and ask for your money back in a lump sum. The contract is designed to provide income for a specific period — either a set number of years or your lifetime — and the insurance company has already invested your money and made commitments based on that schedule.

This is why annuities are considered a major financial decision. You are trading liquidity (access to your money) for certainty (may provide income). If your circumstances change — you need a large sum for an emergency, you move to another country, or you straightforward change your mind — you have limited options. You can continue receiving payments, stop receiving them (which may trigger penalties), or in some cases sell your future payments to a third party at a discount, but you cannot straightforward reverse the transaction.

Frequently Asked Questions

Can I change my mind after I buy an annuity?

Most states have a free-look period — usually 10 to 30 days — during which you can cancel and get your money back without penalty. After that window closes, you are bound by the contract. Some annuities allow partial withdrawals during a surrender period, but these typically trigger charges. Once payments begin, you cannot reverse the decision.

What if I die before the annuity finishes paying?

It depends on the payment option you chose. If you selected a life-only annuity, payments stop when you die and any remaining balance stays with the insurance company. If you chose a survivor option or a term certain, payments continue to your beneficiary or for the remaining term. This is why the payment option you select at purchase is so important.

How do annuity fees work?

Fixed annuities typically have lower fees, often built into the rate the insurance company guarantees. Variable annuities charge ongoing fees — usually 0.5 to 2 percent annually — that cover investment management, administration, and the insurance company's costs. Some annuities also charge surrender charges if you withdraw during the surrender period. Always ask for a full fee schedule before buying.

Can I use retirement account money to buy an annuity?

Yes. You can buy an annuity inside a traditional IRA, Roth IRA, or 401(k). The tax treatment follows the account type, not the annuity type — money from a traditional IRA becomes taxable income when paid out, regardless of whether the annuity is fixed or variable. Some retirement accounts have rules about when you can convert to an annuity, so check with your plan administrator first.

What is the difference between an annuity and a pension?

A pension is income paid by a former employer based on your years of service and salary history. An annuity is a contract you buy yourself with your own money. Both provide regular income, but a pension is earned through employment while an annuity is purchased. Some people use annuities to create pension-like income in retirement.