How Annuities Work in Retirement

By Justin Pritchard, CFP®

Annuities are often sold as retirement planning tools. But people tend to focus on adding money to annuities, while withdrawing retirement income gets less attention. So, how exactly do annuities work in retirement? We’ll cover the basics here, starting with the simplest form of an annuity that pays an income stream for the rest of your life.

On this page:

  • Types of annuities (and how they work)
  • Logistics of using annuities during retirement
  • Some pros and cons of annuities

Annuities are insurance contracts that can help with retirement planning and accumulation. But you need to be careful—there are a few good ways to use annuities and several ways to misuse them. Before you lock up your savings in an annuity, get familiar with how they work, the different types (you might be surprised), and the pros and cons of using an annuity for retirement.

Guaranteed Lifetime Income

A primary goal of retirement planning is to avoid running out of money during your lifetime. There are several strategies for making your money last, and income sources like Social Security and pensions can provide a base of guaranteed income. But when you want even more guaranteed income, an annuity can fill the gap.

Immediate Annuities

The simplest and purest form of an annuity is an immediate annuity. You buy these annuities with a lump sum of money, and the insurance company begins a stream of monthly or annual payments. Typically, those payments last for the rest of your life, but you may have several options available.

  • Single life: The highest monthly income comes when you choose a single life payment. The insurance company pays you for as long as you live, but the payments end at your death. If you die shortly after beginning the annuity, your lump sum of cash does not provide much value to you or your loved ones. 
  • Joint life: If you’d like to protect a spouse or other loved ones, you can add a beneficiary who continues to receive income after your death. That amount might be 100% of your annuity payment, or you might choose a lower amount, such as 50%. When adding another person, your monthly income is generally smaller than with a single-life annuity.
  • Period certain: You can also set a specific number of years Med payments will go to you or your beneficiaries. For example, if you choose a 10-year period certain, payments continue to beneficiaries if you die within the first 10 years. This prevents a situation where you die shortly after starting an annuity, and all of your money goes to waste.

With immediate annuities, you don’t need to manage the investments you put in the annuity during retirement. After purchasing the annuity and setting up payments, the insurance company handles logistics and transfers money to your bank account periodically. However, those arrangements are irrevocable, and you typically can not get your money back in a lump sum after starting an annuity.

Keep reading below, or listen to the explanation by video:

Tip: Immediate annuities get less expensive to buy as you get older, for the most part. Other factors, such as interest rates, can affect how much income you get, but age is important.

Other Types of Annuities

Most people don’t use an annuity for ongoing retirement income as described above. For better or worse, they typically use annuities as accounts for building up assets. The annuities below share basic features of almost any annuity:

  • Convert to lifetime income: Annuities often allow you to convert your assets into a lifetime income stream as described above. But that’s optional, and most people don’t do that. You might also have the option to get a guaranteed lifetime income without needing to “annuitize” (or make that irrevocable conversion to income). More on that below.
  • Tax deferral: Earnings in the account are typically tax-deferred. However, that may not be a benefit for retirement accounts—growth is already tax-deferred in IRAs, 401(k)s, and other retirement accounts.
  • Insurance company guarantee: Any guarantees on payments are dependent on the insurance company making the guarantee. That’s why it’s critical to only work with highly-rated insurers. State and other programs might provide a backstop if your insurer fails, but that’s not a pleasant experience.
  • Tax pitfalls: When taking money out of an annuity, you may owe income tax based on the amount you withdraw.
  • Surrender charges: When you try to withdraw money from an annuity, you may have to pay fees to the insurance company. Annuities typically require that you leave your money in the contract for multiple years—sometimes ten years or more. There may be opportunities to take out 10% of your original deposit each year, but if you value flexibility, proceed with caution.

Fixed Annuities

Fixed annuities are insurance contracts that guarantee to pay you a set amount of interest on the money you invest in the contract. That interest rate is often guaranteed for one or more years, and it may be competitive with bank interest rates. Rates might start high (as teaser rates) to get your attention and fall later, so look closely.

A multi-year guaranteed annuity (MYGA) might be similar to a fixed annuity, but those products have longer rate guarantees and surrender periods.

When using fixed annuities in retirement, you might simply take withdrawals from the account when you need money.

Longevity Annuities

Longevity annuities can provide insurance against outliving your money. Unlike an immediate annuity, these annuities do not start paying out income when you buy one at retirement. Instead, the contract begins payments at a later age (age 80, for example). If you die before then, you might not receive any income. Longevity annuities can help manage taxes in retirement because you can delay required minimum distributions (RMDs), but there are limits on how you can use these products.

Essentially, with a longevity annuity or deferred income annuity, you’re setting money aside for an income stream that starts later in life.

Tip: Deferred income annuities get less expensive, for the most part, the younger you are. Other factors can affect your benefits, but buying early (because you give up flexibility) result in low costs.

Variable Annuities

A variable annuity allows you to invest for growth within an annuity. You can typically choose from investments similar to mutual funds, and you may gain or lose money, depending on how your investments perform. Variable annuities have several layers of expenses, so it’s important to know how much comes out of your investments if you use these products.

Income riders: Variable annuities have a wide range of “riders,” or optional features that can provide guaranteed income for life. For example, a rider might enable you to draw 5% of your account value per year for the rest of your life, regardless of how the investments perform. Riders typically add additional costs on top of the annuity’s base costs.

Guaranteed growth? These annuities can get confusing quickly. For example, you might hear that your account increases by a guaranteed 6% per year, but that might not mean what you think it means. Annuities can have “hypothetical” balances or “income bases” that rise over time—but those are different from your actual account value (that you can walk away with if you cash out). Income riders often pay income using your benefit base, but every contract is different.

Index Annuities

Also known as equity-indexed or fixed-indexed annuities, these products might seem to offer the best of fixed and variable annuities. The sales pitch typically says that you have market exposure for growth, and “you cannot lose money and there are no fees,” but there are always pros and cons.

Beware surrender charges: Index annuities have notoriously long surrender periods, and you may have to pay steep fees if you cash out within ten years (maybe more). A lot can change in 10 years, so you need to decide how comfortable you are with that.

Limits on earnings: While these products may have some exposure to markets, the upside is generally limited. They may “cap” the amount you can earn in a given year, so you don’t participate in the strongest markets (which account for some of the historical returns in the markets). Also, no matter how much the market rises a partial “participation rate” can limit how much of the earnings actually end up in your account.

Growth and income riders: Index annuities can have features similar to variable annuities that pay income for life without the need to annuitize.

If you’re buying one of these with the goal of substantial long-term growth, you may be setting yourself up for disappointment. And if you don’t need long term growth (because you value safety), simpler solutions may be a better fit. There’s a reason these products come with such a compelling sales pitch: Insurance companies and the agents who sell you these products make a substantial amount of money when you buy, but you never see any of that money changing hands.

Keep in mind that an index annuity is very different from standard index mutual funds and ETFs.

How Do Annuities Work in Retirement?

The logistics of using an annuity depend on what type of annuity you have.

Immediate annuities are the simplest. The insurance company sends you money—usually each month. Payment might come by check or electronic transfer, and you’re free to spend the money however you want.

Fixed, variable, and index annuities are more like accounts you can draw from as needed. You just call the insurer when you need money, and request a check or bank transfer for the amount you want. You need to complete forms in some cases, so it’s not always as easy as logging in and zapping money to your bank.

  • Income for life? If you’re taking income with an income rider, the experience might be similar to an immediate annuity. The insurer sends money to your account periodically. You can generally take out more than the guaranteed amount, but doing so may deplete your account balance and reduce your guaranteed income going forward.

Do You Have to Pay Taxes?

Retirees often need to pay taxes after taking withdrawals from an annuity. Several situations can result in taxation:

Pre-tax money: If you fund an annuity with pre-tax money, everything you withdraw is likely to cause tax consequences. Pre-tax accounts might include a traditional (deductible) IRA, pre-tax money in your 401(k) or 403(b), SEP and SIMPLE plans, 457 plans, and more.

Earnings: Even if you fund an annuity with after-tax money, you might owe taxes on withdrawals. The earnings in an annuity are tax-deferred, and withdrawals are often treated as last-in-first-out (LIFO). As a result, you pay taxes on the earnings before you start drawing down your principal, in some cases.

  • Annuitization: With immediate annuities or deferred annuities that you later annuitize, things may work differently. Those level monthly payments might include a portion of taxable income and a portion that’s a tax-free return of your original investment. Research if an exclusion ratio applies to your situation.

It’s complicated: Annuity taxation is incredibly complicated. You might only owe tax on the earnings, or withdrawals may be partially taxable, depending on how you fund an annuity—and how you structure withdrawals. It’s critical to work with your tax advisor to understand the consequences, including the potential need to pay estimated taxes or tax penalties. This article provides a basic overview as food for thought, but you need to speak with a tax advisor who is familiar with your annuity and your tax return before making decisions.

Pros and Cons of Annuities for Retirement

Almost everything in life comes with tradeoffs.

Potential Advantages:

  • Income for life: The primary benefit is the ability to establish an income that can last for your life, regardless of how long that is.
  • “Feels” like a paycheck: Monthly income from an annuity can seem like income from your job or a pension. That makes it easy to fit with monthly expenses.
  • Minimal management: Depending on the annuity you choose, you can wash your hands of investment management duties. The insurance company might handle everything for you.
  • Predictability: You can reasonably expect a set amount each month, regardless of what the markets do. In some contracts, guaranteed growth of an income base can help you make long-term plans.

Potential Disadvantages:

  • Often misused: This explanation could go wide and deep, but let’s just say that annuities might be best used for their guarantees. You may be on the wrong path if you’re not clear on which guarantees you want and the tradeoffs (including costs) of using them.
  • High commissions: It’s fair for salespeople to make a living. But large commissions can lead some people to oversell annuities. Plus, you often have no idea what you’re paying, but insurance companies don’t have any trouble paying compensation or getting their bills paid.
  • High fees, in some cases: Especially with variable annuities, you need to make sure it’s worth the cost. Adding riders can further increase costs.
  • Surrender charges: Long surrender periods can make it painful to get money out of an annuity. Things may change in the coming years, and an annuity can limit your freedom.