Guide · Retirement
Annuities Explained: Trading a Lump Sum for Guaranteed Income
An annuity solves a specific problem — running out of money in retirement — by converting savings into a predictable income stream. Here's how the math behind that conversion actually works.
Immediate vs deferred
An immediate annuity is funded with a lump sum and starts paying out right away — common at the point of retirement. A deferred annuity has an accumulation phase first, often with additional contributions, before payouts begin years or decades later.
How insurers calculate your payment
The math is the same as a loan amortization formula, just reversed — instead of you paying down a loan, the insurer pays down your annuity balance to you, with interest calculated on the declining balance along the way. A larger lump sum, a longer payout term, or a higher crediting rate all change the size of each payment.
What to check before buying
- Surrender charges — penalties for withdrawing more than allowed in the early years.
- Annual fees — mortality and expense charges, rider fees, and fund expenses on variable annuities.
- Insurer's financial strength rating — your guarantee is only as good as the company backing it.
- Inflation protection — a level payment loses purchasing power over a long payout term unless it's inflation-adjusted.
Frequently asked questions
Are annuities a good investment?
Annuities aren't really an investment in the growth sense — they're an insurance product that trades a lump sum for guaranteed, predictable income. They can make sense as part of a retirement income plan to cover essential expenses, but typically aren't the best vehicle for maximizing long-term growth.
What's the difference between a fixed and variable annuity?
A fixed annuity guarantees a specific rate of return and payment amount. A variable annuity's value (and payout) fluctuates with the performance of underlying investment sub-accounts, offering more upside potential but also more risk.
Can I get my money back if I change my mind?
Most annuities have a 'free look' period (often 10-30 days) to cancel without penalty. After that, withdrawing more than a small free amount typically triggers a surrender charge that can run 5-10% in the early years, declining over time.
How are annuity payments taxed?
Outside a retirement account, each payment is split into a tax-free return of principal and a taxable interest/growth portion, using an 'exclusion ratio.' Inside an IRA or other tax-advantaged account, the entire payment is typically taxed as ordinary income.