Annuity Guide: Types, Costs & When They Make Sense
How Annuities Work
At its core, an annuity is an insurance product. You transfer risk to an insurance company: you give them money now, and they guarantee payments later. The insurance company pools money from many customers, invests it, and uses actuarial tables to calculate how much they can promise each person.
Annuities have two phases: the accumulation phase (when you are putting money in and it is growing) and the distribution phase (when the insurance company is paying you). Some annuities — immediate annuities — skip the accumulation phase entirely.
Types of Annuities
| Type | How It Works | Risk Level | Best For |
|---|---|---|---|
| Fixed annuity | Guaranteed interest rate for a set period | Low | Conservative savers who want predictability |
| Variable annuity | Returns tied to sub-account investments (similar to mutual funds) | Medium-High | Investors who want growth potential with insurance features |
| Fixed indexed annuity | Returns linked to a market index (e.g., S&P 500) with a floor and cap | Low-Medium | People who want some market upside with downside protection |
| Immediate annuity (SPIA) | Lump sum converts to income payments starting within 12 months | Low | Retirees who need income now |
| Deferred income annuity (DIA) | Lump sum now, payments begin years later (e.g., at age 80) | Low | Longevity insurance — protection against living too long |
Annuity Fees: What You Are Actually Paying
Annuity fees are where most people get burned. Unlike a low-cost index fund charging 0.03%–0.10%, annuities — especially variable annuities — layer multiple fees that can total 2%–4% per year. Here is what to watch for:
| Fee Type | Typical Range | What It Covers |
|---|---|---|
| Mortality & expense (M&E) | 1.0%–1.5%/year | Insurance company’s profit and risk charge |
| Administrative fees | 0.10%–0.30%/year | Record-keeping and plan administration |
| Sub-account/fund fees | 0.25%–1.00%/year | Underlying investment management (variable annuities) |
| Rider fees | 0.50%–1.50%/year | Optional guarantees (income rider, death benefit rider) |
| Surrender charges | 5%–8% (declining) | Penalty for early withdrawal, typically over 6–8 years |
When Annuities Make Sense
You have maximized all other tax-advantaged accounts — your 401(k), IRA, and HSA are fully funded. An annuity provides additional tax-deferred growth, though at a higher cost than a taxable brokerage account.
You need guaranteed income. If you lack a pension and want a predictable income floor in retirement beyond Social Security, a simple immediate annuity or deferred income annuity can fill that gap. A SPIA is essentially buying yourself a pension.
You are concerned about outliving your money. A deferred income annuity that kicks in at age 80 or 85 is relatively cheap to purchase and provides powerful longevity insurance.
When Annuities Do Not Make Sense
You have not maxed out simpler retirement accounts. If you still have room in your 401(k), IRA, or HSA, those are better tax-advantaged vehicles with lower fees.
You need liquidity. Surrender charges and the illiquid nature of annuities make them poor choices if you might need the money within the next 5–10 years.
You are young. Unless you have a very specific use case, buying an annuity in your 30s or 40s locks up money in a high-fee vehicle when low-cost index funds would likely generate better returns over decades.
Tax Treatment of Annuities
Annuities purchased with after-tax money grow tax-deferred. When you receive payments, the portion representing your original investment (the “cost basis”) is returned tax-free, and the gains portion is taxed as ordinary income — not at the lower capital gains rate. This is a key disadvantage: gains in a taxable brokerage account would be taxed at the more favorable long-term capital gains rate.
Annuities purchased within a traditional IRA or 401(k) do not provide any additional tax benefit — the account is already tax-deferred. This is one of the most common mistakes: buying a tax-deferred product inside an already tax-deferred account.
Key Takeaways
- Annuities convert a lump sum into guaranteed periodic income — they are insurance against outliving your money.
- Fixed and immediate annuities are simple and cost-effective. Variable annuities with riders are complex and expensive (2%–4%+ in annual fees).
- Surrender charges of 5%–8% can lock up your money for 6–10 years — understand the terms before purchasing.
- Only consider annuities after maxing out your 401(k), IRA, and HSA. Never buy an annuity inside a tax-deferred account — it provides no additional tax benefit.
- For longevity protection, a simple deferred income annuity (starting payments at age 80–85) is one of the most cost-effective insurance products available.
Frequently Asked Questions
Are annuities a good investment?
Annuities are insurance products, not investments. They are good at one thing: guaranteeing income. If your primary goal is growth, low-cost index funds will almost always outperform after accounting for annuity fees. If your primary goal is guaranteed lifetime income, a simple annuity can be a smart tool.
What happens to my annuity when I die?
It depends on the type. A life-only immediate annuity stops paying when you die — any remaining value stays with the insurance company. Joint-and-survivor annuities continue paying your spouse. Variable annuities typically pass the account value (or a guaranteed minimum) to your beneficiary. Read the contract carefully — the death benefit terms vary significantly.
Can I get out of an annuity contract?
Yes, but it may be costly. During the surrender period, you will pay surrender charges (typically 5%–8% declining over 6–10 years). Most contracts allow penalty-free withdrawals of up to 10% of the account value per year. After the surrender period ends, you can withdraw or transfer freely. Some states offer a “free look” period (10–30 days after purchase) where you can cancel without penalty.
How much does a $500,000 annuity pay per month?
For an immediate annuity purchased at age 65, a $500,000 lump sum might generate approximately $2,800–$3,200/month (life-only) or $2,400–$2,700/month (joint-and-survivor). Rates vary by insurance company, prevailing interest rates, and your age and gender at purchase. Get quotes from multiple providers.
Should I buy an annuity inside my IRA?
Generally no. An IRA is already tax-deferred, so an annuity inside it provides no additional tax benefit. You would be paying annuity fees for a feature (tax deferral) you already have. The exception might be if you specifically want the guaranteed income feature and are using the IRA for that purpose in retirement.