What Is an Annuity?

Decide if an annuity could be valuable to your retirement plan.

Annuities are financial vehicles that offer investors the opportunity to earn passive income in the future. Since annuities have the potential to pay investors for the remainder of their lives, they are popular components of many retirement plans. Annuities, however, do have drawbacks and they aren’t for everyone. Find out if annuities are right for your retirement plan.

What Is an Annuity?

Annuities are insurance products, but they can be sold by financial institutions as well as insurance companies. Investors buy into annuities under the agreement that they will receive payments in the future. An annuity can pay a lump sum payment. In most cases, however, investors receive annuity payments for a predetermined amount of time or for the rest of their lives.

Related: 5 Best Annuities for Your Financial Plan

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How Do Annuities Work?

Since they offer the potential for income that investors can’t outlive, annuities are popular among people who are saving for retirement. Annuities require investors to put away money for years before seeing any payments, so it’s critical to buy annuities only from a company you confidently believe will be around as long as you are.

Since annuities are insurance products, only professionals with insurance licenses can sell them. Annuities can be complicated investment vehicles, and standards and regulations vary by state. In order to really understand the answer to the question, “how does an annuity work?” consider speaking with a financial advisor before entering into an agreement.

What Are the Different Types of Annuities?

Annuities are insurance contracts that can be written and structured in a variety of different ways. Review the three types of annuities to decide if one might be better for you:

  • Income annuity: This type of annuity requires an investor to sacrifice future access to their own savings in exchange for a lifelong stream of income.
  • Variable annuity: This annuity allows buyers to choose the investments that will be packaged into the annuity and then pays them according to the performance of the investments they select.
  • Fixed annuity: It works a lot like a CD. Unlike variable annuities, they provide guaranteed payments that are determined by the investor’s age and annuity size. Since the payments are steady and predictable, fixed annuities are popular among retirees.

Related: Annuities 101 — Tax-Free Investments for Retirement

Pros and Cons of Annuities

What are some of the benefits and drawbacks of annuities? As noted, annuities have the potential to distribute payments to investors throughout retirement and even for the rest of their lives.

There are also tax benefits. Money put into annuities grows tax-free, even when money is withdrawn. Any earnings, however, are taxed at the regular rate. Unlike other common retirement vehicles like 401ks, there is no limit on how much you can contribute to an annuity.

There is, however, a downside. Annuities are sold by brokers who charge high fees that will eat at your nest egg, sometimes as much as 10 percent. There are also surrender charges, which are penalties for early withdrawals. These charges can reach as high as 20 percent. Finally, some annuities, like variable annuities, come with high annual expenses.

Annuities can provide steady, predictable income for retirement. They come with lucrative tax benefits and are easy to purchase. Annuities, however, are complicated and can be expensive. Knowing exactly what you are buying and who you are buying it from is critical to investing in annuities.

Up Next: 6 Ways to Make Your Retirement Savings Last

About the Author

Andrew Lisa has been writing professionally since 2001. An award-winning writer, Andrew was formerly one of the youngest nationally distributed columnists for the largest newspaper syndicate in the country, the Gannett News Service. He worked as the business section editor for amNewYork, the most widely distributed newspaper in Manhattan, and worked as a copy editor for TheStreet.com, a financial publication in the heart of Wall Street’s investment community in New York City.