A life insurance annuity is a contract with an insurance company that converts your money, paid either as a lump sum or over time, into guaranteed income payments to you. A life insurance policy pays your beneficiaries after you die; an annuity pays you while you’re alive. How much you receive depends on how much you put in, when the payments start, and which type of annuity you buy.
How the Contract Is Structured
Every annuity contract spells out the same core terms: how you fund it, how the insurer will grow the money, and when and how you’ll be paid. State regulators require insurers to give you a disclosure document covering the key features, what is and isn’t guaranteed, all fees, and any surrender charges.1National Association of Insurance Commissioners. Annuity Disclosure Model Regulation If an agent sells you the annuity, that agent has to recommend a product in your best interest and can’t put their compensation ahead of your needs.2National Association of Insurance Commissioners. Annuity Suitability and Best Interest Standard
Two roles run through the contract. The owner controls it, makes financial decisions, and names the beneficiaries. The annuitant is the person whose life expectancy determines the payment amounts and how long they last. Usually these are the same person. They don’t have to be: a trust or another legal entity can own the contract while an individual serves as the annuitant. The beneficiary is whoever receives any remaining value when the annuitant dies, and that designation overrides your will, so it needs to stay current after marriage, divorce, or a death in the family.
Behind the contract, insurers are required to hold financial reserves large enough to cover all future annuity obligations.3eCFR. 26 CFR 1.801-4 – Life Insurance Reserves If the company fails anyway, your state’s guaranty association steps in up to a coverage limit set by state law, typically between $100,000 and $250,000 of the annuity’s present value.4National Organization of Life & Health Insurance Guaranty Associations. How You’re Protected
The Main Types
Annuities differ on two axes: when they start paying you, and how your money grows in the meantime. Most contracts combine one timing choice with one growth choice, so you might own a deferred fixed annuity or an immediate variable annuity.
Immediate vs. Deferred
An immediate annuity starts paying you shortly after you hand over a lump sum, usually within 30 days to 12 months. Retirees who need income right away tend to choose it, often to fill the gap between Social Security and their actual living expenses.
A deferred annuity pushes income into the future and lets your money grow tax-deferred in the meantime. You can fund it with a lump sum or contributions over months or years, and earnings compound without being taxed until you begin withdrawing. The deferral can last decades. If the deferred annuity is held inside a qualified retirement account such as a 401(k) or traditional IRA, federal tax law requires you to start taking minimum distributions in the year you turn 73; under the SECURE 2.0 Act, that age rises to 75 for anyone born after 1959.5Internal Revenue Service. Retirement Topics – Required Minimum Distributions (RMDs)
Fixed Annuities
A fixed annuity guarantees a specific interest rate on your money for a set term, commonly three to six years. After that, the insurer resets the rate annually, but the new rate can never drop below a guaranteed minimum written into your contract. When payout begins, every check is the same size. Fixed annuities suit people who want predictability and no exposure to stock market swings.
Variable Annuities
A variable annuity lets you invest in sub-accounts that work like mutual funds. Returns rise and fall with the market, so you take on investment risk in exchange for the chance of higher growth. During the accumulation phase you allocate money across stock, bond, and money market sub-accounts. When income begins, payments can stay variable or you can lock them in.
Some variable annuity contracts offer a guaranteed lifetime withdrawal benefit that promises a minimum income floor even if the investments perform poorly. That protection costs extra, and variable annuities carry several layers of fees, discussed below.
Fixed Indexed Annuities
A fixed indexed annuity sits between fixed and variable. Returns are tied to a market index such as the S&P 500, but you never lose principal in a down year because the contract includes a floor, typically 0%. In exchange, the insurer caps how much of the index’s gains you actually receive. The contract does that through a participation rate (a percentage of the index gain credited to you), a cap (the maximum interest you can earn in a given period), or a spread (a percentage subtracted from the gain before crediting). Usually only one of these mechanisms applies per crediting strategy, not all three at once.
How You Get Paid
When you’re ready for income, the contract offers several distribution methods. The choice you make generally locks in how payments will work for the life of the contract.
- Life only: Pays a fixed amount each period until you die. Because the insurer keeps any remaining funds, this option produces the highest per-payment amount and leaves nothing for heirs.
- Period certain: Guarantees payments for a set number of years, often 10 or 20. If you die during that period, your beneficiary receives the remaining payments.
- Joint and survivor: Covers two people, usually spouses. After the first dies, the survivor keeps receiving payments, often at a reduced rate such as 50%, two-thirds, or 100% of the original. For qualified plans, the IRS requires the survivor benefit to be at least 50% of the original payment.
- Lump sum: You take the entire accumulated value in one payment, which creates a large tax bill in a single year.
Some contracts also allow systematic withdrawals on a schedule you set, and a few permit accelerated payments if you face a qualifying hardship such as a terminal illness or long-term care need.
If passing money to heirs matters to you, be careful with life-only. A life-only annuity stops paying the moment you die, regardless of what your beneficiary form says. A period-certain or refund option guarantees a minimum total payout even if you die early. And if you name no beneficiary at all, remaining value typically flows into your estate and goes through probate.
What It Costs
Fixed and fixed indexed annuities usually build their costs into the interest rate they offer, so you won’t see a separate fee line. Variable annuities are different. They stack layers of fees that can collectively exceed 2% to 3% a year:
- Mortality and expense risk charge: Compensates the insurer for guaranteeing a death benefit, typically around 1% to 1.25% of account value per year.
- Investment management fees: Each sub-account charges its own fee, similar to a mutual fund expense ratio, often between 0.10% and 1.50%.
- Administrative fees: Cover recordkeeping, usually 0.10% to 0.30% per year.
- Optional rider charges: Guaranteed income or enhanced death benefit riders typically cost an additional 0.50% to 1.50% per year.
These fees compound. An annuity charging a combined 2.5% a year has to earn at least that much just to break even. Add up every layer before you buy, and compare the total against a simpler fixed annuity or a low-cost index fund.
Surrender Charges and Early Withdrawals
Getting out early costs money. During the surrender period, typically six to eight years after purchase, the insurer charges a penalty on withdrawals above a small allowed amount. A common schedule starts around 7% in the first year and drops by roughly one percentage point each year until it reaches zero. Many contracts let you pull out up to 10% of your account value annually without triggering the surrender charge, but not every contract includes that provision. Some contracts waive surrender charges entirely if you’re diagnosed with a terminal illness or need long-term care.
On top of the insurer’s charge, the IRS imposes a 10% penalty on withdrawals from tax-deferred annuities taken before you turn 59½.6Internal Revenue Service. Topic No. 558, Additional Tax on Early Distributions From Retirement Plans Other Than IRAs Exceptions exist for disability, certain medical expenses, and other qualifying circumstances.7Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
How Annuities Are Taxed
Tax treatment depends on whether you funded the annuity with pre-tax or after-tax money, how you take distributions, and whether you’re the original owner or an heir.
A qualified annuity lives inside a tax-advantaged retirement account. Contributions went in pre-tax, so every dollar you withdraw is taxed as ordinary income. A non-qualified annuity is bought with money you’ve already paid tax on, so only the earnings portion of each withdrawal is taxable.
If you take money out of a non-qualified annuity before converting it to a payment stream, the tax code treats earnings as coming out first. Under Section 72(e), any withdrawal that isn’t a regular annuity payment is taxable to the extent it doesn’t exceed the gain in your contract.8Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts You don’t reach your tax-free principal until all the earnings have come out.
Once you actually annuitize a non-qualified contract, each payment splits into a taxable and tax-free portion using what the IRS calls an exclusion ratio: your investment in the contract divided by the expected total return over your lifetime. Invest $100,000 with an expected return of $200,000, and half of each payment is tax-free return of principal and half is taxable earnings.8Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
If you want to swap one annuity for a better one without triggering tax, Section 1035 allows a tax-free exchange for another annuity or a qualified long-term care insurance contract.9Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies The same owner must appear on both contracts, and funds must transfer directly between insurers. Cash out first and the exchange doesn’t qualify.
Inherited annuities have their own rules. A surviving spouse has the most flexibility and can often treat the annuity as their own or delay distributions. Non-spouse beneficiaries generally must withdraw the entire balance within 10 years of the owner’s death if the annuity was held in a qualified plan, though certain eligible beneficiaries (minor children, disabled individuals, and people not more than 10 years younger than the deceased) may stretch payments over their own life expectancy.10Internal Revenue Service. Publication 575 – Pension and Annuity Income
Your Free Look Window
After you receive the contract, most states give you a window, typically 10 to 30 days, to return it for a full refund with no penalty.1National Association of Insurance Commissioners. Annuity Disclosure Model Regulation The free look period should be prominently stated in your contract. If you have any doubt about whether the annuity fits your situation, use it. Once it closes, surrender charges apply.