How do annuities work?

Annuities are insurance products designed to provide you with regular income, often for life. Many also have investment components that can potentially increase their value (and your income).

When you buy an annuity, typically from an insurance company, the provider invests the money with the goal of gaining value over time or generating interest, often while protecting your nest egg. Depending on the type of annuity, you can purchase it with a lump sum of money or contribute to the account over time. And with most annuities, once you buy, you enter the accumulation phase: You continue funding the annuity before payments to you begin.

When you start taking income from your annuity, you're in the annuitization phase. The insurer will begin making regular payments to you. Depending on the kind of annuity you have, you'll get income for either a set period or the rest of your life (like Social Security). This steady stream can help you budget and cover expenses in retirement.

Before you buy an annuity, it's important to understand how it might affect your taxes. There are also events that can reduce the annuity's value (and your eventual payments). For example, different annuities may have different rules for survivor benefits or for what happens if you withdraw money before the date you and the provider agreed upon. (That date will be in the annuity contract. Different annuities have different terms and conditions for withdrawals.)

Annuities with guarantees are backed by the companies that issue them, so it's possible (if unlikely) to lose money with one. So, consider that company's history and track record and read (and understand) the fine print before you buy. To check the health of an annuity provider, review its financial strength rating from one of the leading insurance company analysts, Standard & Poor's, Moody's, or A.M. Best.

Types of annuities

Different kinds of annuities have different characteristics. When choosing, keep in mind your goals and needs.

Fixed vs. variable vs. indexed

A fixed annuity guarantees your principal and offers a stated rate of interest during a set period.

A fixed indexed annuity provides more growth opportunity than fixed annuities, but less potential return than a variable annuity. You decide how much of your money to allocate to a fixed-rate strategy, which grows at a predetermined interest rate. The rest goes to an index-based strategy, which has the potential to grow based on how the index(es) you choose perform. (Some fixed indexed annuities may cap the interest you can earn or the percentage of the underlying index's growth.) Essentially, this type of annuity incorporates elements of both a fixed and an indexed annuity, it protects your money from market loss, but still has potential to grow based on the performance of a market index.

A variable annuity's value depends on the performance of the stock market. As the name implies, its gains (and your potential payout) depend on how its investments perform. If you want exposure to potential market runups, you might gravitate to variable annuities. (At the same time, unless the annuity has protection against market downturns, usually for an extra cost, you can lose money.) These products can also let you begin taking payments immediately or wait until a later date.

An indexed variable annuity pays interest based on the performance of an index, often a large group of stocks that track a portion of the market (like the S&P 500 index of large companies listed on U.S. stock exchanges) rather than the overall market itself. Indexed annuities can provide downside risk protection from market losses but may also set a cap on what returns you receive.

Essentially, fixed annuities provide you with more certainty: You can be reasonably sure of your payments when the time comes. By contrast, variable annuities can generate higher gains but also involve more risk and uncertainty, especially when markets are volatile.

Deferred vs. immediate

A deferred annuity is one you purchase years before you plan to retire. You can usually set up a regular contribution schedule so you can pay into the annuity over time until you're ready to take payments.

You typically buy an immediate annuity with a single, lump sum amount if you want to begin receiving payments right away (or at least soon). Some retirees take money from their retirement accounts and use it to buy an immediate annuity. This way, they can begin getting the regular cash flow they need to cover essential expenses in retirement. (Retirees can also withdraw directly from a retirement plan as they need the money, but that income won't be guaranteed.)

How Does an Annuity Work?

An annuity has two phases: the accumulation phase and the payout phase. During the accumulation phase, the investor pays the insurance company either a lump sum or periodic payments. The payout phase is when the investor receives distributions from the annuity. Payouts are usually quarterly or annual.

What Is the Difference Between a Retirement Plan and an Annuity?

An annuity is a contract with an insurance company, while a retirement plan is offered by a bank or financial services company.

There are two main types of retirement plans: defined-contribution plans such as 401(k)s, and defined-benefit plans, which are also known as pensions.

An annuity's accumulation phase is similar to a defined contribution plan before retirement, and an annuity's payout phase is similar to a defined benefit plan during retirement.

Importantly, either option can shield income from taxes until the money is withdrawn.

Is an Annuity a Good Idea?

Whether to invest in an annuity depends on your financial goals and circumstances.

Because annuities can come with relatively high fees, you might consider other retirement savings vehicles before buying an annuity.

For example, you could max out your 401(k). The Internal Revenue Service (IRS) raises the contribution limits every year to account for inflation. If you are 50 or older, you can make an additional catch-up contribution.