Annuity

An annuity has up to two phases. In the accumulation phase, your money earns interest or investment returns with no tax due along the way. In the payout phase, the insurer turns the contract’s value into regular payments, a step called annuitization. An immediate annuity skips the first phase and starts paying within a year, as with a single premium immediate annuity. A deferred annuity grows first and pays out later, if you annuitize at all; you can take withdrawals instead.

Payments can run for a fixed number of years or for as long as you, or you and a spouse, live. The insurer pools many buyers, so premiums from those who die early help pay those who live long. That pooling makes an annuity the classic hedge against longevity risk.

You can buy an annuity with after-tax money, called a nonqualified annuity, or hold one inside a traditional IRA or a workplace plan such as a 401(k), where it adds no extra tax deferral because the account already has it.

Deferred annuities come in four main types, compared in the table below. Fixed annuities credit a rate the insurer sets. Fixed indexed annuities credit interest based partly on an index such as the S&P 500, never less than zero. Registered index-linked annuities (RILAs) pass along index gains and losses within set limits, and variable annuities rise and fall with the mutual funds you choose.

Indexed crediting is rarely the full index return. Contracts usually exclude dividends and apply a participation rate, a cap or a spread. In the SEC’s own example, a 75% participation rate and a 3% spread turn a 10% index gain into a 4.5% credit, and insurers can often reset those terms over time.

Income annuities exist only to pay you. An immediate annuity starts within a year; a deferred income annuity starts years later, and one bought inside an IRA as a QLAC can also hold part of your required minimum distributions back until as late as 85.

Growth inside an annuity is Tax-Deferred Account. Nothing is taxed until money comes out, and gains are then taxed at ordinary income rates, not the lower capital gains rates.

For a nonqualified deferred annuity, withdrawals before annuitization come out of gains first: under §72(e), each withdrawal is taxable until all the growth has been paid out, and only then do your after-tax premiums come back tax-free. Before 59½, the taxable part also owes a 10% additional tax under §72(q), unless an exception applies, such as death, disability, substantially equal payments for life, or payments from an immediate annuity.

Once you annuitize, part of each payment is a tax-free return of what you paid in, set by the IRS General Rule’s exclusion ratio. The taxable part of a nonqualified annuity also counts as investment income for the 3.8% net investment income tax. Inside an IRA or 401(k), payments are taxed like any other distribution from that account.

A §1035 exchange swaps one annuity for another without tax, but the new contract can restart surrender charges.

Annuity costs come as explicit fees on a statement and as implicit costs built into what the contract credits.

Variable annuities carry the most visible fees. The SEC describes a mortality and expense risk charge typically around 1.25% of account value a year, administration fees often around 0.15%, the expense ratios of the underlying funds, and extra charges for optional riders such as guaranteed lifetime withdrawals. Fixed and indexed annuities often have no explicit ongoing fee; the insurer instead credits less than it earns or caps your gains.

Almost every type has surrender charges. A typical schedule starts around 7% in the first year and falls by a point a year, usually ending after six to ten years, though many contracts allow a free withdrawal of about 10% a year. Some contracts, including RILAs, also apply a market value adjustment to early withdrawals, often negative and on top of any surrender charge. Fees can also fund the seller’s commission, so ask how anyone recommending an annuity is paid.

An annuity’s strengths and weaknesses come from one trade: you give an insurer control of your money in exchange for a promise. Whether that is worth it depends on the income you already have. Many retirees start with a Pension and Social Security, which grows 8% for each year you delay past full retirement age, up to 70, then use an annuity to fill any gap between that guaranteed floor and essential spending in a retirement income plan. Facing a pension buyout instead? See pension lump sum vs. annuity.