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Tuesday, June 20, 2023

ABCs of Annuities

It’s the golden age of annuities, with more of them available in 401(k)s than ever before. But does one belong in your retirement plan?

An annuity is a contract to pay out funds in a fixed income stream in the future, either for a specified time period or for the remainder of the purchaser’s (the annuitant’s) life. They can be bought with a lump-sum payment or monthly premiums. Annuities are primarily a retirement product to help avoid the risk of outliving savings.

Annuities can provide stable, guaranteed income in retirement. However, the investment is subject to penalties for early withdrawal and is not a liquid investment. If you buy an annuity today and need the money to pay medical bills a year from now, you’ll regret your choice. 

Immediate or Deferred (Longevity) Annuities

Immediate annuities begin paying right away. They are often funded with a full payment, such as one gets from a settlement, inheritance, or lottery win. That cash is exchanged for monthly payments guaranteed to continue into the future. 

Deferred annuities grow tax-deferred and provide annuitants with payments that start on a specified date. Sometimes called a “longevity annuity,” contracts can defer payments until age 75 or 85, or whenever the purchaser wants guaranteed income at a point when savings may have run out or become substantially reduced. 

Fixed and Variable Annuities

A fixed annuity provides regular, certain payments to the annuitant regardless of how stock and bond markets may perform.

Variable annuities allow the purchaser to get bigger payments if investments in the annuity fund do well, but the returns will be smaller if those investments go down. The investments in a variable annuity carry market risk, and the principal can be lost. 

To alleviate this risk, annuitants can purchase riders and features that make the product function as a hybrid fixed-variable contract. These may guarantee a base payment regardless of how the market performs, or create a death benefit or accelerate payments if the annuitant has a terminal illness. Another popular rider adjusts payouts annually for inflation based on the consumer price index.


If your annuity is funded with untaxed money, such as money that is held in an IRA or 401(k), then it’s considered a qualified annuity. Payments from a qualified annuity are fully taxable at your ordinary income rate when they are received.

If your annuity was purchased with funds that have already been taxed, such as from a Roth or brokerage account, then it is considered non-qualified. The principal portion of payments won’t be taxed, but the earnings are taxed as ordinary income. 

Find out more about the ins and outs of annuity taxation here.

8 Questions to Ask Before You Buy an Annuity

Before you purchase an annuity, make sure you understand the contract and any riders that are attached to it. Find a comprehensive explanation for each question on the blog page.
  1. What is the rating of the insurance company selling me the product? If the insurance company fails, your annuity won’t be worth anything. This is one case where only the best will do. AM Best ranks superior companies as A+ or A++. Find out the AM Best rating of the insurance company backing your annuity, and make sure it is at the A level. Don’t be misled by assurances that the company is “strong” or “great.” Insist on knowing the AM Best rating.
  2. What is the total annual cost of the contract? Annuities will generally cost more than a mutual fund, sometimes much more. For example, a deferred annuity will typically charge an administrative fee (typically from 0.10 to 0.25%), mortality and expense fees (typically ranging from 1.0% - 1.5%), and fees for optional benefits (ranging between 0.5 – 1.5% per benefit). In addition, variable contracts will generally charge asset management fees, with total fees for a variable deferred contract generally ranging between 1.75% annually for a bare-bones contract, to over 3.25% annually for a contract with income and death benefit guarantees. 
  3. If I invest $100,000 now, what will the contract be worth in a year if the market goes up, stays flat, or falls? The answer is more complicated than it seems. How much will fees take out? Equity index annuities must take into account total market return. Walk away if you can’t answer this question.
  4. Would mutual funds be a better investment for me than an annuity? Mutual funds are cheaper, but they don’t come with any guarantees. Both products may have a place in your portfolio. Make sure you are talking to someone who doesn’t dismiss, or insist on including, either product.
  5. Is the annuity inflation adjusted? An annuity paying out $1,000 per month in 2003 would have to pay out $1,640 in today’s dollars to maintain the same buying power unless it adjusted for inflation.
  6. What are the guaranteed retirement income benefits of the annuity? Deferred annuities usually specify a minimum percentage that can be withdrawn, regardless of how the investments perform. This minimum provides a secure floor during retirement. 
  7. What is the surrender period? This is the amount of time an investor must keep the contract without paying punitive fees. Once you buy an annuity, there is no going back without losing the surrender fee, which is often in place for years. There may be a percentage value of the contract that can be withdrawn annually without incurring surrender fees. 
  8. Will I get a better deal buying an annuity directly from an insurance company or should I work with a financial professional? While you may find a good deal on your own, it’s likely you’ll be better off working with a financial professional such as a Chartered Life Underwriter, Chartered Financial Consultant, or Certified Financial Planner who can evaluate a wide variety of contracts. Be sure to ask how she or he is getting paid. A no-load contract means no commission is paid to the professional, while other contracts are sold on commission

This article is not intended to be a substitute for professional financial advice from a qualified financial advisor.