What is an annuity and how does it work?

An annuity is a contract with an insurance company: you give the insurer money, and it promises to pay you back, either as income that can last for life or as a growing balance you draw on later. Its main selling point is that a lifetime payout is something almost nothing else in personal finance can promise. Its main drawbacks are limited access to your money, fees that vary widely by type, and guarantees that are only as good as the insurer behind them.

The two jobs an annuity does

Annuities do one of two things, and many buyers confuse them.

1. Turn savings into income. You hand over a lump sum and receive payments, sometimes for life. This is the pooling idea behind the comparison with life insurance: people who die early subsidize the payments to people who live long, so the insurer can promise income you cannot outlive.
2. Grow money tax-deferred. You put money in and it earns interest or investment returns that are not taxed until you take them out. Whether that deferral is worth the cost depends heavily on the contract.

The two phases

A deferred annuity has an accumulation phase, where the value builds, and an income phase, where you either withdraw money or convert the balance into payments through annuitization. An immediate annuity skips accumulation: you pay a lump sum and income starts within about a year. The person whose life the payments are measured on is the annuitant, who is often, but not always, the owner.

The main types

The scale of the market shows how popular the category has become. LIMRA reported record U.S. annuity sales of $461.3 billion in 2025, including $160.6 billion of fixed-rate deferred, $128.2 billion of fixed indexed, $79.6 billion of RILA, $65.2 billion of variable and $18.8 billion of income annuities. Sales volume reflects marketing and interest rates as much as suitability.

What it costs and what limits you

• Surrender charges. Most deferred annuities charge a fee, declining over a surrender period, if you withdraw more than a free amount early. Details are in annuity surrender charges and free withdrawals.
• Ongoing fees. Fixed products usually build costs into the declared rate. Variable products and riders carry explicit annual charges. See annuity fees, explained.
• Taxes. Earnings are taxed as ordinary income when withdrawn, and distributions before age 59 1/2 can carry an extra 10% tax unless an exception applies (see IRS Topic 410 and how annuities are taxed). Buying one inside an IRA adds no extra deferral, which is why Should you put an annuity in an IRA? is a separate question.
• Free-look period. Most states give a short window, commonly 10 days or more depending on the state and your age, to cancel after delivery. See free-look period.

How safe are the guarantees?

Guarantees come from the insurer's general account and are only as strong as its claims-paying ability. If an insurer fails, the state guaranty association system steps in up to limits. According to NOLHGA (as of June 1, 2025), most states cover $250,000 of annuity present value, and some go higher. This is not FDIC insurance. Check your state with the state guaranty association coverage lookup and read state life and health guaranty associations. Variable subaccounts are different: their value rises and falls with markets, and that risk is yours, though they are held apart from the insurer's general assets.

A hypothetical illustration

Say a 66-year-old retiree has $400,000 in savings, Social Security that covers most but not all expenses, and a $1,000 monthly gap. They could (a) use part of the savings for an immediate annuity sized to the gap, (b) leave everything invested and withdraw as needed, or (c) do both. Choice (a) reduces the risk of running short but gives up liquidity and, with a life-only payout, leaves nothing for heirs. Choice (b) keeps flexibility and takes market and longevity risk. The annuity payout calculator lets you see how age, payout option and amount change option (a). This is an illustration of mechanics, not a quote.

Who an annuity suits, and who it doesn't

Often suits:

• Retirees who want a predictable floor of income beyond Social Security and any pension.
• People who value certainty enough to give up access to part of their savings.
• Savers who have used lower-cost tax-advantaged accounts and will not need the money for years.

Often does not suit:

• People who may need the money soon, because of surrender charges and tax penalties.
• Buyers who have not used employer plans and IRAs, which are already tax-deferred.
• Anyone being sold a complex product they cannot explain back, or pressured to move money from another product; see annuity sales abuses targeting seniors.
• Those whose main goal is leaving money to heirs, where other tools may be cheaper.

The broader weighing of pros and cons is in are annuities a good idea?.

Questions to ask before buying

1. What is my goal: guaranteed income, safe growth or something else?
2. How long is the surrender period and what is the charge in each year?
3. What are all the fees, including any rider, and how are they deducted?
4. What exactly is guaranteed, for how long, and by whom? What is the insurer's financial strength rating?
5. Is this a security (variable or RILA), and have I received the prospectus?
6. What happens to the money if I die early?

Key takeaways

• An annuity swaps a sum of money for income now or later; the unique value is income you cannot outlive.
• Types differ in who carries market risk, how they are regulated and how much they cost, so the label tells you less than the contract.
• Surrender charges, fees and taxes limit access, so annuities fit money you will not need soon.
• Guarantees depend on the insurer, backed by state guaranty limits, not by FDIC insurance.
• Match the type to one clear goal and ask for every fee and the surrender schedule in writing.