Annuity Basics: What They Are, How They Work, And Types

Shawn Plummer

CEO, The Annuity Expert

What is an annuity?

An annuity is an insurance contract that provides a fixed income stream to the annuitant. It offers a way to address the risk of outliving savings, making it a popular choice for retirement purposes. Annuities can be purchased with either a lump-sum payment or through monthly premiums, allowing individuals to customize their investment approach. With the goal of providing a reliable income source, these retirement vehicles come in different forms and structures.

There are various types of annuities, including immediate and deferred annuities. Immediate annuities start paying out income right away, while deferred annuities delay payments until a future date. This flexibility allows individuals to choose the annuity that best aligns with their retirement goals and timeline.

Investors often opt for annuities as a means of ensuring a steady income during retirement. By investing in annuities, individuals can provide themselves with a reliable source of income, helping to address the uncertainties that can come with retirement. Overall, these plans offer a valuable solution for those planning for retirement and seeking financial security in their golden years.

Annuity TypePayment Start Date
Immediate AnnuityPayments start right away
Deferred AnnuityPayments start at a future date

Key Takeaways

  • Annuities are insurance contracts that offer a reliable income stream for retirement purposes.
  • They come in different types, including immediate or deferred, fixed or variable.
  • Annuities provide tax deferral on investment earnings and protection from creditors.
  • Investors can choose between lump-sum payments or monthly premiums to fund annuities.
  • Annuities can ensure your spouse has financial support if you pass away.
  • Understanding the features, benefits, and considerations of annuities is crucial for retirement planning.

What does “annuity” mean?

Essentially, “annuity” refers to these systematic payments, helping individuals manage the risk of outliving their savings by ensuring a consistent income stream. Different annuity types suit varying financial strategies and risk levels.

An example of annuities is the lottery. If a winner chooses the payout option, the lottery uses an annuity to distribute the payments over time.

How long have annuities been around?

Annuities have existed for centuries, with origins tracing back to ancient Rome. They became more formalized in the 17th century by establishing European annuity markets.

In perspective

  • The IRA was created in 1974.
  • The 401k was created in 1978.
  • The Roth IRA was created in 1997.

How An Annuity Works

Annuities are financial products that go through two distinct phases: the accumulation phase and the annuitization phase. Understanding how these phases work is crucial for anyone considering an annuity as part of their retirement planning strategy.

The Accumulation Phase

During the accumulation phase, investors fund their annuity by making either lump-sum payments or regular premium payments over time. The funds invested in the annuity grow on a tax-deferred basis, meaning that any earnings from the investment are not subject to current income taxes. This allows for potential growth over time without the immediate burden of taxation.

Depending on the type of annuity, investors may have the ability to choose from a variety of investment options to control how their money is invested during the accumulation phase. These options can include stocks, bonds, mutual funds, and other financial instruments. By diversifying their investments, investors can potentially increase their chances of achieving higher returns.

The Annuitization Phase

Once the accumulation phase is complete, the annuity enters the annuitization phase. This is when the annuitant (the person who purchased the annuity) begins to receive payments. The annuitant can choose to receive payments for a fixed period of time, such as 10 or 20 years, or for the rest of their life.

Takeaway: The annuitization phase is optional in most annuity products, and owners can choose to “walk away” from the contract (investment and interest) in a lump sum.

It’s important to note that contracts can be immediate or deferred, which refers to when the annuitant starts receiving payments. Immediate annuities begin paying out shortly after the annuity is funded, while deferred annuities have a waiting period before payments begin. The choice between immediate and deferred products depends on the annuitant’s financial goals and needs.

Overall, an annuity provides a reliable source of income during retirement, allowing individuals to convert their savings into a steady stream of payments. By understanding the accumulation and annuitization phases, investors can make informed decisions about how an annuity can fit into their retirement plans.

How Annuities Work

The Main Types of Annuities

Annuities come in various types, each offering different features and benefits. Understanding the different types can help individuals choose the annuity that best suits their financial goals and needs.

Fixed Annuity

fixed annuity is a type of annuity that offers a guaranteed interest rate over a specific period. It provides a stable and predictable income stream, making it suitable for individuals who prefer a conservative approach to investments. The rate of return on a fixed annuity is not dependent on market performance (except for fixed-indexed annuities), which offers protection against market volatility.

Related Reading: Compare Today’s Best Fixed Annuity Rates

Variable Annuity

variable annuity allows investors to allocate their funds among various investment options such as stocks, bonds, and mutual funds. The return on a variable annuity is based on the performance of these underlying investments, offering the potential for higher returns but also exposing the investor to market risk. Variable annuities are suitable for individuals who are comfortable with market fluctuations and seeking long-term growth.

Immediate Annuity

An immediate annuity provides regular income payments that start immediately after the annuity is purchased. It is often used by individuals who are already in retirement and want to convert a lump sum of money into a steady income stream. Immediate annuities offer the advantage of providing income right away, but they do not allow for further contributions once the contract is initiated.

Deferred Annuity

deferred annuity delays income payments until a later date, allowing the invested funds to grow tax-deferred. It is commonly used for retirement planning, enabling individuals to accumulate wealth over a specified period. Deferred annuities offer flexibility in terms of contribution amounts and timing, making them suitable for individuals who want to save for the future but do not immediately need income from the annuity.

What Is An Annuity?

Comparison of Different Types of Annuities

Annuity TypeGuaranteed IncomeMarket RiskTiming of Income PaymentsFlexibility
Fixed AnnuityYesNoBegins at a predetermined dateLimited
Variable AnnuityNoYesDependent on market performanceHigh
Immediate AnnuityYesNoStarts immediately after purchaseLimited
Deferred AnnuityNoNoDelayed until a later dateHigh

Annuity Contract Features

When considering annuities, it’s important to understand the various contract features that can impact your investment. Here are some key features to consider:

Tax Deferral

Annuities offer tax deferral on investment earnings, allowing for potential growth without immediate taxation. This means that you won’t have to pay taxes on your investment gains until you start receiving payments from the annuity. This tax advantage can help your investment grow over time, providing a potential boost to your retirement savings.

Protection from Creditors

Another important feature of annuities is their ability to offer some level of protection from creditors. This means that in the event of a lawsuit or bankruptcy, the funds in your annuity may be shielded from being used to satisfy your creditors’ claims. The level of protection can vary depending on the state you live in and the type of annuity you have, so it’s important to consult with a financial advisor or attorney to understand the specific protections available to you.

Investment Options and Tax-Free Transfers

Annuities provide a variety of investment options, allowing you to choose how your money is invested. Depending on your risk tolerance and investment goals, you can allocate your funds to different asset classes such as stocks, bonds, or a combination of both. Additionally, annuities often offer the flexibility to transfer funds among investment options on a tax-free basis. This allows you to adjust your investment strategy as needed without incurring any tax consequences.

Contract FeaturesBenefits
Tax DeferralAllows for potential growth without immediate taxation
Protection from CreditorsProvides some level of asset protection
Investment OptionsAllows for customization of investment strategy
Tax-Free TransfersProvides flexibility in asset allocation
No contribution limitsThere are no limitations on how much you can contribute

Understanding these contract features can help you make informed decisions when considering annuities as part of your retirement planning. It’s essential to carefully review the terms and conditions of any annuity contract and consult with a financial professional to ensure that it aligns with your financial goals and objectives.

Benefits and Considerations

When considering annuities, it’s important to understand the various benefits they offer as well as the potential considerations. Here are some key points to keep in mind:

Lifetime Income:

Annuities provide a guaranteed stream of income for the annuitant’s lifetime. This can be particularly advantageous for retirees who are concerned about outliving their savings. With an annuity, you can have peace of mind knowing that you’ll receive regular payments as long as you live.

A Dummies Guide To Understanding Annuities

Benefits to Heirs:

Annuities also offer benefits to heirs. Depending on the type of annuity, you may have the option to name a beneficiary who will continue to receive payments after your passing. This can provide financial support to your loved ones and ensure that your assets are distributed according to your wishes.

Tax Implications:

It’s important to consider the tax implications of annuities. While they offer tax-deferred growth, meaning you won’t pay taxes on investment earnings until you receive payments, withdrawals before a certain age may incur penalties. Additionally, annuity payments are generally subject to income tax. Consulting with a tax advisor can help you navigate the tax aspects.

Surrender Fees:

Some contracts may have surrender fees, which can limit liquidity during a specified surrender period. If you need access to your funds before the surrender period ends, you may incur fees or penalties. It’s essential to carefully review the terms and conditions of any annuity contract and consider your financial flexibility needs.

Overall, annuities can provide a reliable source of lifetime income and benefits to heirs. However, it’s important to weigh the potential tax implications and surrender fees associated with annuities. By carefully considering these factors and consulting with a financial professional, you can make an informed decision that aligns with your financial goals and retirement needs.

Annuities Definition And Meaning

Annuities vs. Life Insurance

When it comes to long-term financial planning, annuities and life insurance are two popular options to consider. While both serve different purposes, they play crucial roles in addressing mortality risk and longevity risk. Here, we’ll explore the key differences between annuities and life insurance, allowing you to make informed decisions based on your specific needs and goals.

Annuities: Managing Longevity Risk

Annuities are designed to address the risk of outliving your savings by providing a guaranteed income stream for as long as you live. By purchasing an annuity, you can ensure a steady flow of payments throughout your retirement years, offering financial security and peace of mind. Annuities come in various types, including immediate and deferred, fixed and variable, allowing you to tailor your investment to your unique circumstances.

Life Insurance: Protecting Against Mortality Risk

On the other hand, life insurance serves as a form of financial protection for your loved ones in the event of your death. By paying regular premiums, you can secure a death benefit that will be paid out to your designated beneficiaries. Life insurance provides financial support to cover expenses such as funeral costs, outstanding debts, and ongoing living expenses for your family. It offers peace of mind knowing that your loved ones will be taken care of in your absence.

While annuities and life insurance have distinct purposes, they are often offered by the same companies as complementary products. This allows individuals to manage both mortality risk and longevity risk within a comprehensive financial plan. Consider consulting with a financial advisor to determine the optimal balance between annuities and life insurance based on your specific circumstances and objectives.

AspectAnnuitiesLife Insurance
Primary PurposeAddress longevity risk by providing a guaranteed income stream throughout retirement.Provide financial protection for loved ones in the event of the policyholder’s death.
PaymentsRegular income payments for as long as the annuitant lives or for a fixed period.Death benefit paid out to designated beneficiaries upon the policyholder’s death.
Risk CoverageAddresses the risk of outliving savings and provides ongoing financial security.Covers the financial needs of beneficiaries after the policyholder’s death.
Tax TreatmentGenerally offers tax-deferred growth on investment earnings.Death benefits are generally tax-free for beneficiaries.
FlexibilityVarious types available, allowing customization to individual needs and goals.Multiple policy options and riders available to tailor coverage.

Annuity Regulations and Suitability

When it comes to annuities, there are important regulations in place to protect consumers and ensure that these financial products are suitable for their needs. The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) are responsible for overseeing the regulation of annuities.

Agents or brokers who sell annuities must hold state-issued life insurance licenses and may also require securities licenses for variable annuities. This ensures that they have the necessary knowledge and expertise to provide appropriate advice to consumers. These licensing requirements help maintain a level of professionalism and accountability in the industry.

In addition to licensing requirements, annuity contracts also have suitability requirements. This means that agents or brokers must assess whether an annuity is suitable for the purchaser’s financial situation, goals, and risk tolerance. This helps prevent individuals from being sold annuities that may not be appropriate for their specific circumstances.

The Importance of Suitability

The suitability of an annuity is crucial because these financial products can have complex features and fees that may not be suitable for everyone. An agent or broker must take into account factors such as the consumer’s age, income, investment objectives, and time horizon. By ensuring that an annuity is suitable, consumers are more likely to make informed decisions and avoid potential pitfalls.

Overall, the regulations surrounding annuities and their suitability requirements aim to protect consumers and ensure that they are provided with appropriate investment options. By working with licensed professionals and considering individual financial goals, individuals can make well-informed decisions when it comes to purchasing annuities and planning for their retirement.

Benefits of Annuity Regulations and SuitabilityConsiderations
Protection for consumersPotential limitations in investment options
Professionalism and accountability in the industryAdditional time and effort to assess suitability
Prevention of unsuitable annuity salesComplexity of annuity features and fees
Increased consumer knowledge and awarenessNeed for ongoing review and evaluation

Why Do People Buy Annuities?

Having familiarized ourselves with the standard definition of annuities, it’s time to delve into their practical applications in daily life. As an annuity broker and trainer since 2009, I’ve accumulated over a decade of experience educating clients and facilitating annuity sales. My journey has revealed that annuities aren’t just retirement tools; they’re versatile financial instruments capable of solving various financial challenges. So, how exactly can an annuity be utilized beyond retirement planning? Let me share the insights I’ve gained, exploring the diverse and often overlooked ways annuities can enhance financial security and flexibility.

  • Long-term savings account for retirement
  • CD-alternative
  • Safe investing vehicle
  • Life insurance alternative
  • Personal pension plan
  • Hedge against inflation
  • Long-term care insurance alternative
  • Asset protector for Medicaid
  • Lottery payments
  • Settlement payments from court cases.

The Biggest Myth About Annuities

A common criticism about annuities is that they make you lose control of your money, but that’s not true. Most plans let you choose to take your investment and earnings in a lump sum or as a series of payments at the end of the contract term.

  • Complexity: While annuities can be complex due to their flexibility, financial professionals can help investors understand their options.
  • Not for High-Net-Worth Investors: Contrary to belief, high-net-worth investors are often likely to purchase annuities.
  • One-Size-Fits-All: There are various types with different rules, limits, and rider options, allowing customization based on individual goals.
  • Only for Retirees: Both current and future retirees find value in annuities, especially those offering lifetime guarantees.
  • Lack of Inflation Adjustment: Some plans allow changes in income amounts to meet changing needs.
  • Lack of Emergency Access: Most permit annual penalty-free withdrawals up to a certain percentage, though full access is restricted until the surrender period ends.
  • Expensiveness: Compared to most investments and retirement plans, its fees are relatively low. Owners pay fees to provide death benefit protection and income guarantees, offering security not present in other investment options.
Annuities Explained


Now that you have this “understanding annuities for dummies guide,” know that these financial tools are the only vehicle that offers guaranteed income for retirement, but it’s crucial to weigh their benefits against fees and liquidity constraints. Tailoring an annuity to your financial goals is key, and seeking advice from a financial advisor (like The Annuity Expert) can be immensely helpful. For a clearer picture and a personalized approach to annuities, contact us today for a free quote, and use our annuity calculator to help estimate your payments.

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Frequently Asked Questions

What is an annuity?

An annuity is an insurance contract that provides a guaranteed income stream, primarily used for retirement purposes to address the risk of outliving savings.

What is the basic function of an annuity?

The basic function of an annuity is to provide a steady stream of income, typically for retirement.

How do annuities work for dummies?

An annuity goes through an accumulation phase and an annuitization phase. During the accumulation phase, investors fund the annuity, and the investment grows on a tax-deferred basis. In the annuitization phase, the annuitant begins receiving payments for a fixed period or the rest of their life.

What are the different types of annuities?

Annuities can be categorized into different types based on their structure. They can be fixed or variable, providing either regular periodic payments or payments based on investment performance. Payments can also be immediate or deferred.

What are the features of an annuity contract?

Annuities offer tax deferral on investment earnings, allowing for potential growth without immediate taxation. They also provide protection from creditors, offering some level of asset protection. Annuities offer a variety of investment options, allow for tax-free transfers among investment options, and provide lifetime income, guaranteeing a steady stream of payments for as long as the annuitant lives.

What are the benefits and considerations of annuities?

Annuities offer benefits to heirs, allowing for payments to continue after the annuitant’s death. However, there are tax implications, and withdrawals before a certain age may incur penalties. These long-term contracts may also have surrender fees, which can limit liquidity during a specified surrender period.

How do annuities compare to life insurance?

Annuities address longevity risk, ensuring income for as long as the annuitant lives, while life insurance provides a death benefit to the policyholder’s family upon their death. Both insurance policies serve different purposes, although life insurance companies often offer annuity products as a natural hedge to their insurance products.

How are annuities regulated, and what are the suitability requirements?

Annuities are regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Agents or brokers selling annuities must hold state-issued life insurance licenses and may require securities licenses for variable annuities. Annuity contracts have suitability requirements, ensuring they are appropriate for the purchaser’s financial situation and goals.

Are annuities investments?

Yes, annuities are a type of investment designed for income stability, especially during retirement, where money paid in grows and is later paid out as a steady income stream.

What is the annuity definition?

An annuity is a financial product that pays out a fixed stream of payments to an individual, typically used as an income stream for retirees.

What is the annuity meaning?

“Annuity” derives from the Latin word “annuitas,” which means “annual payment,” and is related to “annus,” the Latin word for “year.”

What does an annuity protect the annuitant against?

An annuity protects the annuitant against outliving their income by providing regular payments for life or a specified period.

What is an annuity primarily designed to protect?

An annuity is primarily designed to protect against outliving one’s savings. It guarantees a steady income stream over a specified period or for the rest of one’s life. Individuals can contribute to an annuity during their working years and receive regular payments upon retirement, providing financial security and stability.

Shawn Plummer

CEO, The Annuity Expert

Shawn Plummer is a licensed insurance agent and annuity broker with over a decade of first-hand experience. Since beginning his journey in 2009, he has been pivotal in selling and educating about annuities and insurance products. Still, he has also played an instrumental role in training financial advisors for a prestigious Fortune Global 500 insurance company, Allianz. His insights and expertise have made him a sought-after voice in the industry, leading to features in renowned publications such as Time Magazine, Bloomberg, Entrepreneur, Yahoo! Finance, MSN, SmartAsset, The Simple Dollar, U.S. News and World Report, Women’s Health Magazine, and many more. Shawn’s driving ambition? To simplify retirement planning, he ensures his clients understand their choices and secure the best insurance coverage at unbeatable rates.

The Annuity Expert is an independent online insurance agency servicing consumers across the United States. The goal is to help you take the guesswork out of retirement planning and find the best insurance coverage at the cheapest rates

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