Annuities explained from A to Z

In a recent Gallup poll, 34 percent of Americans say they are banking on annuities and insurance plans to fund their retirement. The same survey noted that among the current crop of retirees, 31 percent say annuities are now providing them income.

Annuity: What it is and how it works

An annuity is a financial product that provides an individual income during his or her retirement or over a certain period of time. Many consumers prefer annuities because of the promise of a steady income.

Annuities work in this manner: a consumer purchases one from an insurance company. On a future date or over a series of dates, the insurance company provides payments to the consumer. The money paid out will follow a certain schedule - it can be per month, per quarter or per year. In certain cases the payment can even be a lump sum. How much the payment is will be based on a number of factors to include the length of the time the consumer makes payments.

The consumer can choose receiving payments for the remainder of his life or over a certain period of time.

What can an annuity do for me?

There are a number of possibilities with annuities:

  • You can use it to meet a part of or your entire retirement goal. Retirement plans like 401(k)s and IRAs have limitations when it comes to contributions. Those who started late in saving money may come up short in their retirement funds. And, pensions and social security may also turn out to be inadequate in funding retirement. This is where an annuity can come in.
  • You can use it to manage and diversify your portfolio. Financial gurus agree that annuities can serve to balance a portfolio that has high-risk investments.
  • It can be used as protection in case you outlive your assets. Immediate annuities can provide income indefinitely.
  • It can be used as protection of assets against creditors. When creditors run after you, all they can access is the annuity payments as they are made and not the money you already have invested in the insurance company.

Advantages and disadvantages of annuities


  • Tax Deferral - annuities have tax-deferred status. This means that the money invested therein will not be subject to tax; only when withdrawn.
  • No limits on contributions - also, there are no phase out schedules on incomes.
  • Payout is guaranteed - annuity holders are given the assurance that they will get paid until the day they die.
  • Protection from creditors - annuities are usually granted exemption from creditors. This however, may vary from state to state.
  • Exemption from being declared an asset under the Free Application Of Student Aid - this allows the student to get a bigger loan or grant amount.


  • Expensive - annuities are generally considered among the costliest investment instruments in the market.
  • Illiquid - there are steep penalties if you withdraw early. There is also a ten percent penalty on premature distribution for those who withdraw before they reach the age of 59 and a half.
  • Very complex - even veteran investors have a hard time understanding the intricacies of annuities.
  • Considered as ordinary income under tax laws - this means there is no likelihood that withdrawals get treated as capital gains.

Types of annuities

Annuities are generally categorized according to the following:


A fixed annuity makes payments based on a guaranteed interest rate. 

This type of annuity can either be immediate or deferred. The latter type accumulates based on regular interest rates while the former provides payments that are fixed during the retirement period. Payments on immediate type of fixed annuities are arrived at using annuity size and age of the individual.

Pros of fixed annuities: payments are based on guaranteed rates, minimum investment required is low --- in the $1,000 to $10,000 range, interest is not taxed until it is withdrawn.

Cons: they have expensive surrender fees and they are not protected against inflation.


This type of annuity presents a mix of features found in fixed and variable annuities. Just as in fixed types, there is a guaranteed interest rate generally in the 2 percent to 3 percent range. And, just as in variable types, there is an opportunity to get higher returns if the performance of the stock market is on an upswing.

Pros of equity-indexed annuities: a chance to enjoy higher returns when the market is positive; also provides protection when the market is on a decline.

Cons: complex and difficult to understand, they do not provide the full return provided by the index to which they are attached. Also, surrender charges are costly - up to 20 percent.


In comparison to a fixed type of annuity, a variable annuity provides the consumer the choice of what investments to contribute to and then makes the payouts based on how those investments performed.

Pros of variable annuities: grow faster than the inflation rate, provides greater opportunity for growth, withdrawals are tax-deferred.

Cons: if the wrong investments are made, the annuity's value will decline, gains are subject to tax, variable fees can be costly - commissions alone can cost up to 4 percent.


Works in similar fashion as a life insurance policy. Payments are made right away. Usually purchased by individuals already in retirement.

When consumers buy them, they pay a lump sum in place of regular premiums. The insurance company then provides the consumer regular payments until he dies. Usually, deferred annuities are convertible to immediate annuities.

Pros of immediate annuities: payments are received right away, income is guaranteed and no worries about not having sufficient funds during retirement, also, what you get may even be higher than with other investments made on your own. An immediate, variable policy may get you payments that are protected against inflation.

Cons: with an immediate, fixed annuity, there is no protection against inflation. In the case of immediate, variable annuities, the downside is the steep costs.


This type of annuity protects an individual against the possibility of outliving his funds later in his life. Longevity annuities require an individual to wait until he is eighty years old to before he starts receiving payments. The later the individual opts to receive payments the larger the amounts get.

Pros of longevity annuities: low premium, provides protection against a risk that individuals in their advance stages of life will not have the ability to handle on their own - the possibility of not having enough funds.

Cons: if the individual dies before the payouts are made, his heirs will get nothing.

How annuities are taxed

How an annuity is taxed depends on whether it is qualified or non-qualified. Annuities purchased through an employer are likely to be qualified. Whereas those purchased by consumers on their own are likely to be non-qualified.

Qualified annuities are treated in the same manner as 401(k)s.  Contributions are considered as pretax dollars. No taxes are paid on gains made by the investments on an account. However, the individual will owe the government taxes when he withdraws his contributions. On the other hand, contributions on non-qualified annuities are considered as after tax dollars. Interest earned is treated on a tax-deferred basis. Taxes are paid when withdrawals are made during retirement.

Shopping for an annuity

The general rules are:

Get an immediate annuity when:

  • you are approaching age of retirement
  • your savings are not enough for your retirement
  • social security and other investments are insufficient
  • you think you will outlive what you have saved
  • no one will be there to help you if you run out of money
  • you want guaranteed income for you spouse if you die ahead of him or her

Get a deferred annuity when:

  • under the age of forty
  • creditors are likely to target your assets
  • thinking of swapping an annuity with poor performance

Other points to consider when shopping for an annuity:

  • Compute how much you will get based on how much you will put in. You can use one of our calculators for this purpose. Depending on the type of annuity you consider go to the Fixed Annuity Calculator, the Variable Annuity Calculator or the Immediate Annuity Calculator.
  • See how financially capable is the company.
  • Know how the payouts are computed.
  • Total all the costs.
  • Consider a death benefit.
  • Know how much it will cost you if you cancel and withdraw.
  • Shop for annuities with low fees.

Surrendering an Annuity

  • Get in touch with the insurance company and ask for forms needed for surrendering your annuity
  • Go over the surrender charges. Usually, these will decrease each year. Surrendering during the early stages, however, can cost you dearly.
  • Compute for the taxes you have to pay because of the withdrawal.
  • Get the total amount that you have to pay for surrendering the annuity. Include here the charges for early withdrawal and the taxes due. Plan out how you can offset the charges.
  • Mail the forms to the insurance company and then await response.

Other important features to consider

  • The period where you are allowed a "Free Look" - here you can return the policy and get a full refund.
  • Accumulation time period - the period that starts from the date the annuity is issued up to the date the firm starts making out payments.
  • Annuitization - the process where contributions are converted into payouts.
  • Distribution Period - the period when the individual gets to receive the payouts. This can be over a certain time period or over a liftetime.
  • Early / premature withdrawals - what are the consequences, how much is the surrender charge, and how taxes are applied to withdrawals.
  • Surrendering - what the process is and how much will it cost you when terminating an annuity contract.
  • Withdrawal charges - see how much the insurance company sets these charges.

Different types of annuity riders

The more common ones are:

  • Long-term care - coverage for unforeseen events. Here withdrawal charges are lessened or waived. Generally provided during the first year of the annuity.
  • Terminal illness - allows withdrawal of a certain percentage of the account's value when the individual is diagnosed with a terminal illness.
  • Survivor and joint - makes it possible for payments to continue even after the policyholder dies.
  • Half survivor and joint - payments continue after the policyholder dies but is only half of the income originally computed.
  • Death benefit - provides assurance that when the individual dies prior to the start of the payoff period, the named beneficiary will get the value of the account or total premiums accumulated, whichever is greater.
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