An annuity is a long-term financial contract between you (the annuitant) and an insurance company. You pay the insurer a sum of money (either a lump sum or in payments over time), and in return, the insurer agrees to make payments back to you for a set period or, most commonly, for the rest of your life.

The main purpose of an annuity is to create a reliable, guaranteed stream of income, typically for retirement.

Think of it as creating a “personal pension.” Its core function is to solve “longevity risk”—the risk that you will outlive your retirement savings.

There are three main parties:

• The Owner: The individual who buys and owns the contract and makes the decisions.
• The Annuitant: The person whose life expectancy is used to calculate the payments. The annuitant and the owner are often the same person.
• The Beneficiary: The person(s) who will receive any remaining value or death benefit from the annuity after the owner or annuitant passes away.

Annuities are categorized by how they grow (their investment type) and when they pay out (their distribution type).

The three main types based on growth are:

1. Fixed Annuities
2. Variable Annuities
3. Fixed-Indexed Annuities

A Fixed Annuity is the simplest type. It works much like a Certificate of Deposit (CD). The insurance company provides you with a guaranteed, fixed interest rate for a specific period.

• Best for: Conservative individuals who prioritize safety, principal protection, and predictable returns.
• Risk: Low. Your principal is protected, but your returns may not keep up with inflation.

A Variable Annuity allows you to invest your premium into various sub-accounts, which are similar to mutual funds.

• Best for: Individuals with a higher risk tolerance who want the potential for stock market-like gains inside a tax-deferred annuity wrapper.
• Risk: High. Your account value can go up or down with the market, and you can lose principal. They also typically have higher fees than other annuity types.

A Fixed-Indexed Annuity is a hybrid. Your returns are linked to the performance of a market index, like the S&P 500.

• How it works: You get some of the market’s upside, but you are protected from the downside. This is done with:
  • A “Cap”: The maximum interest you can earn in a good year.
  • A “Floor”: The minimum interest you can earn (usually 0%). This means you cannot lose money in a market downturn.
• Best for: Individuals who want better-than-fixed-annuity returns but without the risk of losing principal.

This describes when your payments start.

• Immediate Annuity: You pay the insurance company a single lump sum, and your income payments begin right away (typically within one to 12 months). This is for people who need income now.
• Deferred Annuity: You pay a lump sum or make payments over time. Your money grows (the “accumulation phase”) and you begin taking payments at a later date (the “distribution phase”). This is for people who are still planning for retirement.

When you are ready to receive income, you “annuitize” the contract. You will be given several payout options. The most common are:

• Life Only: You receive payments for the rest of your life. This provides the highest monthly payout but payments stop when you pass away, and there is no death benefit.
• Joint and Survivor: You receive payments for your life and the life of your spouse. When one person passes, the survivor continues to receive payments (either the full amount or a reduced percentage) for life.
• Period Certain: You receive payments for a guaranteed period (e.g., 10 or 20 years). If you pass away before the period is over, your beneficiary receives the remaining payments.
• Life with Period Certain: A hybrid. You receive payments for life, but you are also guaranteed that payments will last for a certain period. If you die within that period, your beneficiary gets the remaining payments.

Annuity taxation depends on how you bought the annuity.

1. Non-Qualified Annuity (Most Common):
   • You funded this with after-tax dollars.
   • Your money grows tax-deferred.
   • When you withdraw money, you only pay ordinary income tax on the earnings, not the principal you put in.
2. Qualified Annuity:
   • You funded this with pre-tax dollars (e.g., by rolling over a 401(k) or IRA).
   • 100% of your withdrawals will be taxed as ordinary income.

Important: Withdrawals from any annuity before age 59½ may be subject to a 10% IRS penalty in addition to ordinary income tax.

This depends on your contract and payout choice.

• During the Accumulation Phase (Deferred): If you die before turning on income, your named beneficiary will receive the contract’s value, typically as a lump-sum death benefit.
• During the Distribution Phase (Immediate): This depends on the payout option you chose. If you chose “Life Only,” payments stop. If you chose “Joint and Survivor” or “Period Certain,” your beneficiary or spouse will continue to receive payments as specified in the contract.

1. Guaranteed Lifelong Income: The ability to create a “personal pension” you cannot outlive.
2. Principal Protection: Fixed and Fixed-Indexed annuities protect your principal from market loss.
3. Tax-Deferred Growth: Your money grows without you having to pay taxes on the interest or gains each year.
4. Peace of Mind: They remove the guesswork and stress of managing withdrawals and market volatility in retirement.

1. Illiquidity: Your money is locked up. Most contracts have a surrender charge period (often 5-10 years), during which you will pay a significant penalty for withdrawing more than a small, allowed amount (e.g., 10%).
2. Fees & Complexity: Variable annuities, in particular, can have high fees (mortality, administrative, investment fees, and rider costs). Contracts can be complex and challenging to understand.
3. Inflation Risk: The fixed payments from a fixed annuity may lose purchasing power over time due to inflation. (Some annuities offer inflation-protection riders for an extra cost.)

Annuities are generally best for individuals who are approaching or already in retirement and have two primary goals:

1. They want to protect a portion of their savings from market risk.
2. They want to create a guaranteed, pension-like income to cover their essential expenses (like housing, food, and healthcare).

They are typically considered after you have already maxed out other tax-advantaged retirement accounts like a 401(k) or IRA.

Annuities are considered safe, but their safety is different from a bank account.

• They are NOT FDIC insured.
• They are backed by the financial strength and claims-paying ability of the issuing insurance company.
• If an insurer fails, your policy is protected by your State Guaranty Association up to a certain limit. This is why it is critical to buy an annuity from a highly-rated, financially stable insurance company.