How Does an Annuity Work?

During my years as a licensed financial coach, I set up annuities for many clients. They wanted a steady source of income during retirement as part of a diversified plan.

Annuities typically are included in a strategy to provide a steady income flow during retirement. They can be effective options for individuals whose employers do not offer pensions.

What an Annuity Is

An annuity is a financial product designed to provide a regular, guaranteed income stream over a specified time or for the rest of a person’s life. The individual creates a contract with an insurance company, makes a lump-sum payment or a series of payments, and receives regular disbursements beginning immediately or in the future.

Participants in an Annuity

Three participants are involved in an annuity:

• Owner: The individual who purchases the annuity and pays the premiums

• Annuitant: The individual, typically the owner, who receives the annuity disbursements

• Beneficiary: The individual who receives the death benefit when the annuitant dies

How an Annuity Works

A basic overview of setting up an annuity involves four steps:

1. The individual works with an insurance company, bank, or broker to select the type of annuity and pays into the plan.

2. The insurance company, bank, or broker invests the payment(s) so the annuity earns interest.

3. When the annuitant decides to receive payments, the payments include a return of the original investment and interest, minus fees.

4. The annuitant receives income.

Types of Annuities

An individual’s financial goals, desired payout timeframe, and the fee structure impact the type of annuity selected. The types of annuities include:

• Immediate annuity: Payout begins soon after a premium payment is made.

• Deferred annuity: Payout begins at a future date.

• Fixed annuity: Payout is the guaranteed amount in the contract.

• Indexed annuity: A guaranteed return is provided with the option to share in investment market earnings.

• Variable annuity: Accumulation and payout are variable. Minimum guarantees could be an option at an additional cost. Charges include mortality and expense, contract fees, administrative fees, and the cost of the underlying investment options.

How an Annuity Is Taxed

Money in an annuity grows tax-free. Taxes are applied when funds are dispersed. Delayed taxation can help the account value grow. Consult a tax advisor for more information on the structures and implications. 

What to Consider Before Investing in an Annuity

An individual should consider the following when deciding whether to invest in an annuity:  

• Annuities vary by their structure, terms, fees, payouts, penalties, and potential changes.

• The money invested in an annuity, other than the contractual withdrawal amounts, typically is not accessible until the payout phase begins.

• There might be penalties for early withdrawals if the annuitant is not yet 59 ½, or both.

• Talking with a licensed financial professional before investing in an annuity is encouraged.  

*This information is for educational purposes only.