An annuity is a financial contract between you and an insurance company designed to provide a consistent income stream, often during retirement. By paying either a single lump sum or multiple payments over time, you receive guaranteed payouts later, which can be monthly, annually, or for life. This transforms your savings into a dependable income source, minimizing the risk of outliving your money.
Historical Background of Annuities
The annuity concept dates back to ancient Rome, where citizens paid a sum to receive annual payments often intended to support retired soldiers or their families. Over centuries, annuities evolved as European governments used them to raise funds, promising steady income to investors. In the U.S., insurance companies introduced annuities in the late 1800s, growing in popularity as employer pensions became less common.
How Annuities Work: Two Phases
- Accumulation Phase: You contribute money either as a lump sum or periodic payments. The funds grow tax-deferred until withdrawals begin.
- Payout (Annuitization) Phase: You receive payments based on your annuity terms—these payments can be fixed or variable, for a defined period or for life.
Types of Annuities
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Fixed Annuities: Offer guaranteed interest rates and steady payments, similar to a high-yield savings account. Ideal for stability and predictable income. Learn more in our Fixed Annuity guide.
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Variable Annuities: Investment-based, allowing you to direct funds into sub-accounts like mutual funds. Returns vary with market performance, carrying higher risk and potential reward; fees may be higher. See our Variable Annuity article for details.
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Indexed Annuities: Combine features of fixed and variable annuities by linking returns to a stock market index like the S&P 500. They provide upside potential with protection against losses (a floor). Explore more about indexed annuities in our Deferred Annuity page.
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Immediate vs. Deferred Annuities: Immediate annuities start payments soon after a lump sum payment, fitting those ready for retirement income. Deferred annuities grow funds before payouts begin, suitable for long-term savers. Understand timing options in our Immediate Annuity and Deferred Annuity glossaries.
Who Should Consider an Annuity?
Annuities work best for individuals nearing or in retirement seeking predictable lifetime income, risk-averse investors wanting principal protection with some growth, or those who have maximized retirement accounts and want additional tax-deferred options. However, annuities are illiquid and may carry significant fees, so they’re less suitable for younger investors, those needing quick access to funds, or those prioritizing inflation protection without added costs.
Key Considerations
- Understand all associated fees, especially with variable annuities.
- Know the surrender charges and liquidity restrictions.
- Verify the financial strength of the insurance company backing the annuity.
- Use annuities as part of a diversified retirement income plan.
- Obtain professional financial advice tailored to your situation.
Common Mistakes to Avoid
- Overlooking liquidity constraints.
- Ignoring the impact of fees.
- Relying solely on annuities for retirement income.
- Purchasing annuities within tax-deferred accounts unnecessarily.
- Neglecting inflation’s effect on fixed payments.
- Failing to shop around for the best rates and terms.
For more detailed strategies on retirement income, see our Retirement Income Strategies resource.
External authority: For official IRS guidelines on annuities, refer to IRS Publication 575.