How Do Annuities Work?

One of the biggest challenges in retirement is turning your savings into income that can last for decades. During your working years, income usually comes from a paycheck. In retirement, that paycheck has to be recreated from savings, investments, Social Security, and other sources. Annuities were built to address one specific worry that shows up for almost every retiree: the fear of outliving your savings.

At its core, an annuity is a long-term contract between you and an insurance company. You agree to pay the insurer a lump sum or a series of payments, and in return the insurer agrees to pay you a certain amount at regular intervals for a specific period of time. How long that lasts, and how much you receive, depends on the type of annuity.

Put simply, an annuity works in two steps: you pay an insurance company now, and it pays you income later, for a set period or for the rest of your life.

Here is how the pieces work, from the two phases to the features every annuity shares.

Immediate versus deferred

One of the first things to understand is timing. Some annuities offer immediate payment options, known as immediate annuities, which start paying income soon after you buy them. Others are designed for growth and will not pay out until a set period has passed, often years. Those are deferred annuities. Whether you want income now or growth for later shapes which type makes sense.

The two phases

Many annuities move through two phases. During the accumulation phase, you make payments and your money grows, sometimes at a fixed rate, sometimes tied to an index, and sometimes invested in the market, depending on the type. During the payout phase, the insurer pays your money back to you, either as a lump sum or as payments over a set period or for the rest of your life.

The features every annuity shares

Whichever type you consider, a few things are generally true:

• Tax-deferred growth. Annuity funds and their growth are taxed only when you withdraw, at ordinary income rates, with a possible additional 10% federal penalty for withdrawals before age 59.5.
• Probate bypass. Annuities typically bypass the probate process when you name a beneficiary.
• Fees and charges. Not all annuities have ongoing fees but some do. Any applicable fees, optional rider costs, and surrender charge schedules are clearly outlined in the contract before you purchase.
• Flexible funding. They can be funded with after-tax dollars, or with pre-tax dollars as part of a qualified retirement plan.

Why the type matters

Not all annuities are created equal. The word annuity describes a whole category of products, and each type is built for a different job. That is why the same contract structure can produce very different results depending on whether you choose a fixed, indexed, immediate, or variable annuity. To decide whether one is suitable for you, it helps to understand the basic types and their tradeoffs.

The bottom line

An annuity is a contract between you and an insurance company that can help protect your principal, grow your savings tax-deferred, generate guaranteed lifetime income, or accomplish a combination of these goals. The type of annuity, its features, and how you plan to use it are what determine whether it's the right fit for your retirement strategy.

If you want to talk through how annuities work and whether one fits your situation, we’re happy to help. Consider scheduling a complimentary, no-obligation call. We can review your goals, walk through your income options, and figure out whether an annuity makes sense for you.