What an annuity does with your money

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 pay you a stream of income — either when ready, later, 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 promised payments back to you.

The core trade-off is straightforward: you exchange a large amount of money now for smaller, predictable payments later. How much you get back, when you get it, and how long it lasts depends on the type of annuity you buy and the terms you choose at the time of purchase.

Key Takeaways

  • You pay an insurance company a lump sum or series of payments, and they pay you income in return, either when ready or at a future date you choose.
  • when ready annuities begin payments within a year; deferred annuities delay payments until a date you set, sometimes decades away.
  • Fixed annuities pay the same amount every period; variable annuities tie payments to investment performance and can change month to month.
  • Annuity payments are taxed as ordinary income in the year you receive them, and withdrawals before age 59½ typically face a 10% penalty plus income tax.
  • Once you buy an annuity, you cannot get your principal back — the insurance company owns the money and you own the income stream it generates.

when ready annuities start paying you right away

With an when ready annuity, you hand over a lump sum to an insurance company, and within 12 months they begin sending you regular payments. Those payments continue for a period you choose at purchase — often for life, for a set number of years, or until a specific date.

The amount of each payment is calculated at the time you buy the annuity and is based on your age, the size of your initial payment, current interest rates, and how long the insurance company expects to pay you. A 65-year-old who pays $100,000 will receive a different monthly amount than a 75-year-old who pays the same amount, because the 75-year-old has fewer years left to receive payments.

when ready annuities are often used by people who have just retired and want to convert a portion of their savings into may provide monthly income right away. The payments are predictable and do not change (in a fixed when ready annuity), which makes budgeting straightforward.

Deferred annuities delay payments until you choose to start them

A deferred annuity works differently: you give the insurance company money now, but the payments do not begin until a future date you specify — sometimes years or even decades away. During that waiting period, your money grows inside the annuity contract, either at a fixed rate set by the insurance company or tied to the performance of investments you choose.

Deferred annuities are often used as long-term savings vehicles. You might buy one at age 50 and set it to begin payments at age 70, giving your money 20 years to grow before you need the income. Some people use them alongside retirement accounts like 401(k)s or IRAs to create multiple income streams that start at different times.

The longer you wait before taking payments, the larger each payment typically becomes, because your initial contribution has had more time to grow. However, if you need the money before the payment date you chose, withdrawals usually trigger a surrender charge — a penalty imposed by the insurance company for taking money out early. These charges can be substantial and are separate from any tax penalties.

Fixed annuities pay the same amount every time

A fixed annuity guarantees a specific payment amount for each period — monthly, quarterly, or annually. The insurance company sets an interest rate when you buy the contract, and that rate determines your payment size. Once set, the payment does not change, regardless of how the stock market performs or what happens to interest rates in the broader economy.

This predictability is the main appeal of fixed annuities. You know exactly how much money will arrive each month for as long as the contract specifies. For someone who wants certainty and does not want to monitor investments, a fixed annuity removes that burden entirely.

The trade-off is that if inflation rises or interest rates climb, your fixed payment loses purchasing power over time. A $2,000 monthly payment in 2024 buys less in 2034 if inflation has occurred, and the annuity contract does not adjust for that. Some fixed annuities offer inflation-adjustment riders (add-ons you can purchase) that increase your payment by a set percentage each year, but these riders reduce your initial payment amount.

Variable annuities tie payments to investment performance

With a variable annuity, your payment amount changes based on how the investments inside the contract perform. You choose from a menu of investment options — typically mutual funds or similar portfolios — and your money is invested in those choices. If investments perform well, your payment increases; if they perform poorly, your payment decreases.

Variable annuities appeal to people who believe they can earn higher returns by taking on investment risk, or who want their income to potentially keep pace with inflation through market growth. However, this flexibility comes with uncertainty: your monthly payment is not may provide and can fluctuate significantly from one period to the next.

Variable annuities also typically carry higher fees than fixed annuities. You pay for investment management, insurance costs, and administrative expenses. These fees are deducted from your account value and reduce the amount available for your payments. Some variable annuities include guarantees (called riders) that promise a minimum payment even if investments perform poorly, but these guarantees add to the cost.

How annuity payments are taxed

Annuity payments are taxed as ordinary income in the year you receive them. If you bought the annuity with pre-tax money (such as funds from a traditional IRA or 401(k) rollover), the entire payment is taxable. If you bought it with after-tax money, only the earnings portion of each payment is taxed; the portion that represents your original contribution is returned tax-free.

The insurance company will send you a 1099-R form each year showing how much you received and how much is taxable. You report this on your tax return just as you would any other income. The tax rate you pay depends on your overall income and tax bracket for that year.

If you withdraw money from a deferred annuity before age 59½, you typically owe a 10% early withdrawal penalty on top of ordinary income tax on the earnings portion. This penalty is separate from any surrender charges the insurance company may impose. Once you reach 59½, the 10% penalty no longer applies, though ordinary income tax still does.

What you cannot do once you own an annuity

An annuity is not a liquid investment. Once you buy one and the contract is in force, you own the income stream it generates, but the insurance company owns your principal. You cannot straightforward withdraw your original lump sum and walk away.

If you need money before the scheduled payment date, you can surrender the contract — meaning you ask the insurance company to cancel it and return your remaining balance. However, surrender charges typically explore, especially in the early years of a deferred annuity. These charges can range from 5% to 10% of your account value and decrease over time as you hold the contract longer.

Some annuities allow you to take a small percentage of your account value each year without a surrender charge (often called a free withdrawal amount), but this is limited and varies by contract. You cannot borrow against an annuity the way you can with some other investments, and you cannot transfer it to someone else without triggering a taxable event.

Frequently Asked Questions

Can I change my mind after I buy an annuity?

Most states have a free-look period (usually 10 to 14 days) during which you can cancel the contract and receive a full refund. After that period ends, you can still surrender the annuity, but surrender charges explore. These charges are highest in the first few years and gradually decrease. Check your contract for the specific surrender schedule.

What happens to my annuity if the insurance company fails?

Each state has a guaranty association that protects annuity holders if an insurance company becomes insolvent. Coverage limits vary by state but typically protect up to $250,000 per person per insurance company. Before buying an annuity, you can verify the financial strength of the insurance company through rating agencies like A.M. Best or Moody's.

Can I leave my annuity to my heirs?

This depends on the payout option you chose. If you selected a life-only annuity, payments stop when you die and nothing goes to your heirs. If you chose a period-certain option (payments for 10 years, for example), any remaining payments go to your beneficiary. Some annuities include a death benefit rider that guarantees your heirs receive at least your original investment if you die early.

Is an annuity the same as a pension?

Both provide regular income, but they work differently. A pension is funded and managed by an employer or union, and you receive payments based on your salary and years of service. An annuity is a contract you buy individually from an insurance company using your own money. You control the terms and the amount you invest; with a pension, the employer decides the benefit amount.

What is the difference between an annuity and a life insurance policy?

Life insurance protects your family by paying a lump sum if you die. An annuity protects you by providing income while you are alive. Some products combine both features, but they serve opposite purposes: insurance pays when you die; an annuity pays while you live.