How Do Annuities Work?

Educational PurposeThis article explains the basic structure of an annuity contract, how money may accumulate, how retirement income may be received, and which contract terms deserve careful review.

An annuity is a contract between an individual and an insurance company. The individual provides money through one payment or a series of payments, and the insurer agrees to provide benefits according to the contract. Those benefits may include future income payments, accumulation features, death benefits, or optional guarantees.

1. The Basic Annuity Process

An annuity generally involves four steps:

• Money is placed into the contract.
• The contract may accumulate value.
• The owner decides when and how to access the money, subject to the contract terms.
• The insurer provides withdrawals, scheduled income, lifetime income, or another available benefit.

The exact process depends on whether the annuity is immediate or deferred and whether its growth is fixed, index-linked, or connected to investment options.

2. Funding the Contract

An annuity may be purchased with:

• One lump-sum payment.
• Several scheduled payments.
• Flexible contributions over time, when permitted by the contract.
• Money transferred or rolled over from another eligible account.

Money paid into an annuity is commonly called a premium or purchase payment.

The contract may also establish:

• Minimum contribution amounts.
• Maximum contribution limits.
• Dates when additional payments are allowed.
• Whether new contributions begin a new surrender-charge period.

These terms should be confirmed before purchasing or adding money.

3. The People Connected to an Annuity

An annuity may involve several different roles.

The Owner

The owner controls the contract and may have authority to:

• Make permitted withdrawals.
• Select certain contract options.
• Change beneficiaries.
• Request income payments.
• Surrender the contract.

The Annuitant

The annuitant is the person whose age and life expectancy may be used to calculate certain income benefits.

The owner and annuitant may be the same person, but they do not have to be.

The Beneficiary

The beneficiary is the person or entity designated to receive any available death benefit after the death covered by the contract.

Because these roles may affect ownership rights, taxes, income calculations, and estate planning, they should be selected carefully.

4. Immediate and Deferred Benefits

Immediate Annuity

With an immediate annuity, income generally begins relatively soon after the purchase payment.

A person may provide a lump sum to the insurance company and select an income option such as:

• Income for life.
• Income for a defined number of years.
• Joint income covering two people.
• Another payment option available under the contract.

Deferred Annuity

A deferred annuity is designed for benefits that begin later.

During the waiting period, the contract may accumulate value according to its terms. The owner may later take withdrawals, receive scheduled payments, or convert the contract into an income stream when the contract allows it.

5. The Accumulation Phase

Many deferred annuities have an accumulation phase.

During this period:

• Purchase payments are added to the contract.
• Interest or investment-related growth may be credited.
• Contract fees or charges may be deducted.
• Withdrawals may be permitted, restricted, or subject to charges.
• The owner prepares for income at a future date.

How the value changes depends on the type of annuity.

Fixed annuity

Interest is credited according to rates and guarantees stated in the contract.

Indexed annuity

Interest may be calculated partly by reference to the performance of a market index, subject to contract features such as participation rates, caps, spreads, floors, and crediting methods.

Variable annuity

The value may rise or fall based on the performance of selected investment options, commonly called subaccounts. Variable annuities may also include insurance features and optional benefits for additional charges.

These categories will be explained more fully in Different Types of Annuities Explained.

6. Tax-Deferred Growth

Earnings inside a nonqualified annuity generally grow tax-deferred. This means federal income tax is typically postponed until earnings or taxable amounts are distributed.

Tax deferral does not mean that the earnings are permanently tax-free.

The tax treatment may depend on:

• Whether pretax or after-tax money funded the contract.
• Whether the annuity is held inside a retirement plan.
• Whether money is taken as a withdrawal, lump sum, or scheduled income.
• The owner’s age when money is withdrawn.
• The amount considered earnings versus the owner’s investment in the contract.

Placing an annuity inside an IRA or another tax-deferred retirement account does not create an additional layer of tax deferral because the retirement account already receives tax-deferred treatment.

Tax rules can be complex. Contract owners should obtain guidance from a qualified tax professional before making withdrawals, exchanges, transfers, or income elections.

7. Accessing the Money

Depending on the contract, an owner may be able to access money through:

• Partial withdrawals.
• Systematic withdrawals.
• A full surrender.
• Scheduled income payments.
• Annuitization.
• An optional withdrawal-benefit rider.

These methods are not interchangeable. Each may produce different:

• Income amounts.
• Tax consequences.
• Fees.
• Contract values.
• Death benefits.
• Future guarantees.

Before choosing a distribution method, the owner should understand how that decision affects the remaining contract.

8. What Is Annuitization?

Annuitization is the process of converting the annuity’s value into a series of income payments under an available payout option.

Options may include:

Life-only income

Payments generally continue for the annuitant’s lifetime but may stop at death, even when the total payments received are less than the amount originally used to purchase the income.

Life income with a guaranteed period

Payments continue for life. When death occurs during the selected guaranteed period, payments may continue to a beneficiary for the remainder of that period.

Joint-and-survivor income

Payments may continue while either of two covered individuals remains alive, according to the selected terms.

Period-certain income

Payments continue for a defined number of years rather than for an uncertain lifetime.

The option selected can materially affect the amount of each payment and whether any remaining payments continue to a beneficiary.

Annuitization may also be difficult or impossible to reverse once payments begin. The contract should be reviewed carefully before making an irrevocable income election.

9. Income Riders Are Not Always the Same as Annuitization

Some annuities offer optional income or withdrawal-benefit riders.

A rider may allow the owner to withdraw a calculated amount periodically while keeping the contract in force, subject to its rules. This is not necessarily the same as annuitizing the contract.

Important distinctions may include:

• Whether the owner retains access to the contract value.
• Whether income continues after the contract value reaches zero.
• How the income base is calculated.
• Whether the income base is available as a lump sum.
• What happens after an excess withdrawal.
• The annual cost of the rider.

A displayed “benefit base” or “income base” may be used only to calculate future benefits and may not equal the contract’s actual cash value.

10. Withdrawals and Surrender Charges

Many annuities are designed as long-term contracts.

A surrender charge may apply when an owner withdraws more than the contract permits or terminates the contract during a specified period. The charge often declines over time until the surrender period ends. Some contracts may begin a separate surrender period for later contributions.

Before withdrawing money, review:

• The surrender-charge schedule.
• The amount available without a surrender charge.
• Possible market-value adjustments.
• Rider consequences.
• Taxable income.
• Possible tax penalties.
• The effect on future income and death benefits.

An annuity should generally not be used for money that may be needed soon unless the contract provides adequate liquidity for that need.

11. Fees and Contract Costs

Costs vary by annuity type and may include:

• Administrative charges.
• Mortality and expense charges.
• Investment-option expenses.
• Surrender charges.
• Rider fees.
• Transfer or transaction charges.
• Spreads or other limitations affecting credited interest.

Variable annuities may have higher annual expenses than many conventional investment products because they combine investment features with insurance-related benefits. Optional guarantees can add further costs.

Some annuity costs are deducted directly. Others may be reflected in how interest or index-linked gains are calculated rather than appearing as a separate line item.

12. What Supports the Guarantees?

An annuity is an insurance-company contract.

Guarantees are based on the issuing insurance company’s financial strength and claims-paying ability. They are not guarantees from a bank, an investment market, or the federal government. If the insurer experiences financial difficulty, its ability to meet contractual obligations may be affected.

Before purchasing, consumers should review:

• The full legal name of the issuing insurer.
• Independent financial-strength ratings.
• The insurer’s claims-paying history.
• State insurance-department information.
• Whether more than one insurer is involved in the recommendation.

Financial-strength ratings are opinions, not guarantees, and may change.

13. The Free-Look Period

State law generally provides a limited period after receiving an annuity contract during which the purchaser may review and cancel it according to applicable rules.

This is commonly called the free-look period. Its length and refund provisions vary by state and contract. Investor.gov notes that the period is often approximately 10 to 30 days.

During this period, review:

• Owner, annuitant, and beneficiary information.
• Premium amounts.
• Interest-crediting terms.
• Income-benefit provisions.
• Surrender charges.
• Withdrawal limits.
• Fees.
• Riders.
• Death benefits.
• Contract exclusions.

Do not rely only on a sales illustration or verbal explanation. The written contract controls the benefits and obligations.

14. A Simplified Example

Suppose an individual places $100,000 into a deferred annuity.

The process may look like this:

• The insurance company issues the contract.
• The money enters the accumulation phase.
• Interest or investment-related results are applied according to the contract.
• Charges and withdrawals affect the contract value.
• At retirement, the owner reviews available distribution options.
• The owner may select withdrawals, scheduled income, annuitization, or another available benefit.
• Taxes may apply when taxable amounts are distributed.

This example explains only the general process. It does not estimate income or imply that a particular annuity is appropriate.

15. Questions to Answer Before Moving Forward