What Are Annuities? Different Types And How They Work

Annuities occupy an unusual space in personal finance. They’re sold by insurance companies, but they function more like investment accounts with an insurance wrapper. The basic promise is straightforward: you hand over money now, and the insurer sends you regular payments later. How much you pay, when payments start, and how long they last all depend on which type of annuity you buy.

That basic idea has been around for centuries, but the modern annuity market has grown into something far more varied. There are fixed annuities that work like CDs with better tax treatment, variable annuities that expose you to market risk, and indexed products that try to split the difference. Each type carries its own fee structure, risk profile, and tax treatment.

What Are Annuities?

An annuity is a contract with an insurance company that obligates the insurer to make payments to you. Those payments are typically disbursed monthly, though some contracts allow quarterly or annual distributions. The payment period can last for a fixed number of years, or it can continue for as long as you live.

The flexibility is broader than most people realize. You can fund an annuity with a single lump sum or spread your contributions over years. Payouts can begin within 30 days of purchase or be deferred until you’re 80. The contract can cover just you, or it can include a joint option that continues payments to a surviving spouse.

Insurance companies can make these guarantees because they pool risk across thousands of annuity holders. Some people will outlive their expected payout period, and some won’t. The insurer invests your premium in bonds and other fixed-income instruments, earns a spread on the returns, and uses actuarial tables to price the contract so it stays profitable on average. It’s the same pooling concept behind life insurance, just running in the opposite direction.

How Do Annuities Work?

Every annuity moves through two distinct phases. Understanding what happens in each phase is the key to knowing whether a given annuity fits your situation.

The Accumulation Phase

This is the period when you’re putting money in and the insurer is growing it. With a fixed annuity, the insurer credits a declared interest rate to your account. With a variable annuity, your money goes into sub-accounts that invest in stocks, bonds, or money market funds, and the value rises or falls based on market performance.

During accumulation, your gains grow tax-deferred. You don’t owe income tax on the interest, dividends, or capital gains inside the annuity until you start taking money out. That deferral is one of the main reasons people buy annuities after they’ve maxed out their 401(k) and IRA contributions.

The Payout Phase (Annuitization)

When you’re ready to start receiving income, you annuitize the contract. The insurer converts your accumulated value into a stream of payments based on your age, the payout option you select, and current interest rates. Once you annuitize, the decision is usually permanent.

You typically choose from several payout structures. A life-only option pays the highest monthly amount but stops when you die, even if that’s two years after annuitization. A life-with-period-certain option pays a lower monthly amount but guarantees payments for at least 10 or 20 years, even if you die early. A joint-and-survivor option continues payments to your spouse after your death, though at a reduced rate. I’ve watched people agonize over this choice more than any other part of the annuity process, and for good reason, because it locks in decades of income.

Types Of Annuities

Fixed Annuities

Fixed annuities are the most stable and predictable option. You pay a lump sum or series of premiums, and the insurer guarantees a fixed interest rate for a set period. As of early 2026, top-rated carriers are offering multi-year guaranteed annuity (MYGA) rates between 5.00% and 5.65% on five-year terms, which is roughly in line with CD rates but with the added benefit of tax deferral.

The payout can begin immediately or be deferred until retirement or any date you choose. Deferred fixed annuities accrue interest at rates that are competitive with certificates of deposit, and in many cases slightly higher because the insurer doesn’t have to pay FDIC premiums.

Advantages

• Interest rates are guaranteed for the contract term
• Investment minimums are low, often as low as $1,000
• Interest is not taxed until the money is paid out
• Principal is protected from market losses

Disadvantages

• Interest rates may reset lower after the initial guarantee period
• Surrender charges of 5-8% apply if you withdraw early, typically over a 5-10 year period
• Fixed payouts lose purchasing power to inflation over time

Fixed annuities make sense if you’re concerned that your savings and whatever pensions you have won’t last through your full retirement, and you want a predictable payment that covers at least your baseline expenses. In 2025, fixed-rate deferred annuity sales reached $165.3 billion, making them the single largest annuity product category.

Variable Annuities

Variable annuities share the same basic structure as fixed annuities, with one significant difference: instead of a guaranteed return, the value of your annuity depends on the performance of investments you select. You pick from a menu of sub-accounts offered by the insurer, usually stock, bond, or balanced portfolios that function like mutual funds.

If the markets perform well over your accumulation period, your account value can grow far beyond what a fixed annuity would have produced. The downside is equally real. If your investments perform poorly, your principal shrinks, and your eventual income stream shrinks with it.

Advantages

• If your investments perform well, your principal and future income can grow significantly
• The value of your annuity may outpace inflation
• Gains are tax-deferred until withdrawal

Disadvantages

• If investments underperform, your principal decreases
• Long-term capital gains inside the annuity are taxed as ordinary income when withdrawn, which is a higher rate than capital gains tax
• Total annual fees often run 2-3.5% when you add up M&E charges, fund expenses, and optional rider costs
• Sales commissions can reach 4-8% of the premium

Variable annuities might be a good fit if you’ve already maxed out your 401(k) and IRA contributions and you want additional tax-deferred growth with exposure to equity markets. They’re less suitable if you need guaranteed income and can’t tolerate the possibility of losing principal.

Equity-Indexed Annuities

Equity-indexed annuities (also called fixed indexed annuities) sit between fixed and variable products. They offer a guaranteed minimum return, typically around 1-3%, while also giving you a chance to earn more if a stock market index performs well. The return is tied to an index like the S&P 500, the Dow Jones Industrial Average, or the Nasdaq Composite.

The way the insurer calculates your credited return is where these products get complicated. Most indexed annuities use a combination of participation rates, cap rates, and spreads to limit how much of the index gain you actually receive. For example, if the S&P 500 gains 12% in a year but your contract has a 7% cap, you get credited 7%. If it has a 75% participation rate instead, you get 9%. Some contracts apply both a participation rate and a spread, which layers one reduction on top of another.

Indexed annuity sales hit a record $128.2 billion in 2025, according to LIMRA. That growth reflects demand from people who want some market upside without the full downside risk of a variable annuity. I’ve talked with buyers who were drawn in by the “best of both worlds” pitch, and while that’s not entirely wrong, the cap and participation rate mechanics mean your actual returns in a strong bull market will be well below what you’d earn holding an index fund directly.

Advantage

• Combines a guaranteed minimum payment with the possibility of higher returns in rising markets

Disadvantages

• Complex crediting methods with caps, participation rates, and spreads that limit upside
• Dividends from the index are typically excluded when calculating your return
• Surrender charges can be substantial, often 8-10% in the early years with surrender periods as long as 10-16 years

Indexed annuities are for people who want some connection to market performance but aren’t willing to accept the full downside risk that comes with a variable annuity. They work best when you have money that isn’t essential for your baseline retirement expenses.

Immediate Versus Longevity Annuities

Any of the three annuity types described above can be structured as either an immediate or a longevity product. This distinction controls when your payments start and significantly affects how much each payment is worth.

Immediate annuities begin paying out within 30 days of your initial investment. You hand over a lump sum, and the insurer starts sending checks the following month. These are popular with retirees who need income right now and want to convert a portion of their savings into a pension-like payment. In 2025, single premium immediate annuity (SPIA) sales reached $14.4 billion.

Longevity annuities, sometimes called deferred income annuities, delay the payout until an agreed-upon age, often 80 or 85. By deferring for that long, you allow the principal to grow and you give the insurer a longer window to invest your money. The result is a significantly higher monthly payment than you’d get from an immediate annuity funded with the same amount.

If you buy a longevity annuity at 65 and defer payments until 80, you’re betting that you’ll live long enough to collect. If you pass away at 78, the insurer keeps whatever’s left unless you purchased a return-of-premium rider. Immediate annuities carry less of that risk because you start collecting almost right away, which makes it far more likely you’ll recover your investment.

I’ve seen people use both types in combination. They’ll convert part of their savings into an immediate annuity to cover baseline expenses starting at 65, and put a smaller amount into a longevity annuity that kicks in at 80 or 85 as a hedge against an unexpectedly long retirement. It’s not a common strategy, but it’s one of the more thoughtful approaches I’ve run into.

How Much Does An Annuity Cost?

Annuity costs are layered, and the total expense depends heavily on which type you buy. Fixed annuities are the cheapest to own. Variable annuities are the most expensive. Indexed annuities fall somewhere in between, though their costs are often harder to see because some fees are baked into the crediting formula rather than charged explicitly.

A variable annuity with a 1.25% M&E fee, a 0.90% average fund expense, and a 1% income rider runs about 3.15% per year in total ongoing charges before any surrender fees. Over a 20-year accumulation period, that fee drag can consume a substantial share of your returns.

Fixed annuities have far lower visible fees because the insurer builds its profit margin into the spread between what it earns on your premium and the rate it credits to you. You won’t see an annual fee statement, but the cost is there in the form of a lower credited rate than the insurer is actually earning on its portfolio.

How Are Annuities Taxed?

Annuity taxation depends on whether you funded the contract with pre-tax or after-tax dollars. If you bought the annuity inside an IRA or other qualified retirement account, the entire withdrawal is taxed as ordinary income, the same treatment your IRA distributions receive.

If you bought the annuity with after-tax money (a non-qualified annuity), only the earnings portion of each withdrawal is taxable. Your original premium comes back to you tax-free because you already paid tax on it, and the IRS uses what’s called an exclusion ratio to split each payment into a tax-free return of principal and a taxable gain.

Withdrawals taken before age 59 and a half are subject to a 10% early withdrawal penalty on the taxable portion, on top of ordinary income tax. That penalty applies whether the annuity is qualified or non-qualified. The second trigger is the surrender charge from the insurer, which is a separate contractual penalty that has nothing to do with the IRS.

One tax disadvantage that catches people off guard involves inherited annuities. When the annuity owner dies, the beneficiary owes income tax on the accumulated gains. Unlike stocks or real estate, annuities do not receive a stepped-up cost basis at death. I’ve seen families surprised by five-figure tax bills on inherited annuities that had been growing tax-deferred for 15 or 20 years.

Invest With Care

Annuities can serve a real purpose in a retirement plan, but they’re not the right product for everyone. Before you commit, sit down with a fee-only financial advisor or a registered broker who can walk you through the specific contract you’re considering. Fee-only advisors are worth the consultation because they don’t earn commissions from annuity sales and have no financial incentive to push you toward a product you don’t need.

Make sure you understand the full fee structure, including M&E charges, fund expenses, rider costs, and surrender penalties.

Ask for the contract’s surrender schedule in writing so you know exactly when your money becomes fully accessible. Understand the tax treatment of your specific situation, especially if you’re buying with after-tax dollars and need to plan for the exclusion ratio.

I’ve seen too many cases where someone bought an annuity based on a dinner seminar pitch and didn’t fully understand what they’d signed until they tried to access their money three years later. The product itself isn’t the problem. The problem is buying the wrong type, paying too much in fees, or locking up money you might need sooner than you expect.