An annuity is a contract between you and an insurance company. You give the insurer a lump sum or series of payments, and in return they promise to pay you income — either immediately or at a future date. Annuities are used primarily for retirement income planning. They can solve a real problem (running out of money in retirement) but they come in many forms, carry significant fees and complexity, and are frequently oversold. Understanding the basics helps you decide if an annuity belongs in your plan.
The Main Types of Annuities
Immediate Annuity
You hand the insurer a lump sum, and they start paying you income right away — usually within a month. The payment amount depends on your age, the deposit amount, current interest rates, and the payout option you choose. A life annuity pays as long as you live. A joint-and-survivor annuity continues payments to a spouse after you die. An immediate annuity provides the simplest, most predictable income stream but gives up control of the principal.
Deferred Annuity
You contribute now, the money grows inside the contract, and income payments begin at a future date you choose. Deferred annuities have an accumulation phase (growth) and a distribution phase (income). Within deferred annuities, there are three main subtypes:
- Fixed annuity: Grows at a guaranteed interest rate set by the insurer. Predictable, low risk, no market exposure. Works similarly to a CD but offered by an insurer.
- Variable annuity: Invested in subaccounts (similar to mutual funds). Returns vary with market performance. Higher upside but also downside risk. Typically the most expensive type due to subaccount fees plus insurance charges.
- Fixed-indexed annuity (FIA): Returns are linked to a stock market index (like the S&P 500) but with a floor (you cannot lose principal in down years) and a cap or participation rate that limits upside. A middle ground between fixed and variable.
How Annuities Grow Tax-Deferred
Inside an annuity, gains grow tax-deferred — you do not owe taxes on interest, dividends, or gains each year. You pay ordinary income tax on earnings when you withdraw them. Unlike IRAs and 401(k)s, there are no annual contribution limits on non-qualified (after-tax) annuities. This makes them useful for high earners who have maxed out other tax-advantaged accounts and want additional tax deferral.
However: when you withdraw earnings from a non-qualified annuity, they are taxed as ordinary income — not at the lower capital gains rate. Long-term capital gains are taxed at 0%, 15%, or 20%, while ordinary income can be taxed up to 37%. This is an important disadvantage versus a taxable brokerage account for investors in high brackets.
Annuity Fees
Variable annuities in particular are known for high costs. Common charges include:
- Mortality and expense (M&E) fee: 1–1.5% annually — the core insurance charge
- Subaccount expense ratios: 0.5–2% annually for the underlying investment funds
- Rider fees: 0.5–1.5% per year for guaranteed income riders or death benefit riders
- Surrender charges: If you withdraw too much too early (usually within the first 5–10 years), you pay a penalty — often starting at 7–8% and declining each year
The total annual cost of a variable annuity can easily exceed 3%, which significantly erodes long-term returns compared to low-cost index funds.
When an Annuity Makes Sense
- You have maxed out your IRA and 401(k) and want additional tax deferral
- You are approaching retirement and want to guarantee income you cannot outlive
- You are risk-averse and value principal protection (fixed or fixed-indexed annuities)
- You are concerned about longevity risk — the risk of living longer than your money lasts
When to Be Cautious
- You are young — tax deferral in a taxable brokerage account with index funds (at capital gains rates) often beats an annuity’s ordinary income tax treatment over decades
- You need liquidity — surrender charges lock up your money for years
- You are being sold a variable annuity inside a 401(k) or IRA — the tax deferral is redundant and you are paying extra fees for no benefit
Bottom Line
Annuities are tools, not investments. The right annuity in the right situation — particularly a simple fixed or immediate annuity for retirement income guarantees — can provide real peace of mind. Variable annuities with high fees and surrender charges often benefit the salesperson more than the buyer. Before purchasing any annuity, understand all fees, surrender periods, and how the tax treatment compares to alternatives. Get a second opinion from a fee-only fiduciary financial advisor.
For more on this topic, see our guide on how variable annuities work and when they make sense.