What Is an Annuity? Definition, Types, and Tax Treatment

What Is an Annuity?

An annuity is a contract between a buyer and an insurance company that provides the buyer with a regular series of payments in return for a lump-sum payment. An annuity is most commonly used to establish a steady stream of income in retirement.

Various options for annuities may specify a set number of payments, a guaranteed payment for life, or payments for the life of a surviving spouse.

Understanding Annuities

Most buyers of annuities aim to create a steady stream of income as retirement income. They pay for the annuity either with a lump sum or with a series of payments over time.

In either case, the funds are invested and the proceeds accrue on a tax-deferred basis until they begin receiving payments. Like 401(k) contributions, funds in the account can only be withdrawn without penalty after age 59½. Unlike 401(k) contributions, the money paid into the annuity account is not shielded from income taxes.

Many aspects of an annuity are tailored to the specific needs of the buyer. An annuity that begins paying out immediately is referred to as an immediate annuity, while one that starts at a predetermined date in the future is called a deferred annuity.

The duration of the disbursements also is chosen by the buyer. You can choose to receive payments for a period of time, such as 25 years or for life. A couple can choose a payment that lasts for the life of the surviving spouse.

All of these decisions affect the amount of the payments, usually monthly, that the buyer will receive. In the case of a lifetime annuity, the payment amount also is determined by the buyer's life expectancy based on actuarial tables.

Fixed, Variable, or Indexed?

Annuities come in three main varieties: Fixed, variable, and indexed. Each type has its own level of risk and payout potential.

Fixed

Fixed annuities pay out a guaranteed amount.

This type of annuity comes in two different styles—fixed immediate annuities, which pay a fixed rate right now, and fixed deferred annuities, which pay at a later date.

The downside of this predictability is a relatively modest annual return, generally slightly higher than the interest on a certificate of deposit (CD) from a bank.

Variable

Variable annuities provide an opportunity for a potentially higher return, accompanied by greater risk.

In this case, the buyer decides how the money will be invested, selecting from a menu of mutual funds that go into a personal "sub-account."

The payments are based on the performance of investments in the sub-account.

Indexed

Indexed annuities fall somewhere in between the fixed and variable choices when it comes to risk and potential reward. The buyer receives a guaranteed minimum payout but a portion of the return is tied to the performance of a market index, such as the S&P 500.

Despite their potential for greater earnings, variable and indexed annuities are often criticized for their relative complexity and the fees that are charged for them. For example, there can be steep surrender charges if the buyer chooses to withdraw their money within the first few years of the contract.

Tax Treatment of Annuities

An important feature to consider with any annuity is its tax treatment. While the balance grows on a tax-deferred basis, the disbursements you receive are subject to federal income tax.

The funds you receive are taxed at your regular income tax rates. By contrast, mutual funds that you hold for over a year are taxed at the long-term capital gains rate, which is generally lower.

Additionally, unlike a traditional 401(k) account, the money you contribute to an annuity doesn't reduce your taxable income.

For this reason, financial planning experts often recommend that you consider buying an annuity only after you've contributed the maximum to your pre-tax retirement accounts for the year.

The Bottom Line

An annuity offers one way of providing a predictable stream of income for retirement costs. Many options are available, and you need to consider them all before making a decision. You will be parting with a substantial amount of cash in return for a guaranteed income, for life or for an extended period of time.

If you decide to go for an annuity, compare providers. They differ in the types of annuities they sell and the fees they charge.