How do annuities work in retirement plans?

Annuities are insurance products designed to provide income in retirement. You buy an annuity by paying a premium (either a single lump sum or a series of payments). In return, the insurer promises periodic payments either right away (an immediate annuity) or at a future date (a deferred annuity). Payments and guarantees depend on the annuity type and contract terms.

This article explains the main annuity types, key tax and fee rules (updated to 2025), how annuities interact with IRAs and 401(k)s, practical uses, and the questions you should ask before buying. This is educational content—not personalized financial advice. Consult a licensed financial or tax professional for recommendations tailored to your situation.

Sources: IRS guidance on retirement plans and annuities, Consumer Financial Protection Bureau (CFPB), and industry disclosures on indexed and variable annuities.

Quick overview of the main annuity types

  • Fixed annuity — Pays a guaranteed interest rate and fixed income payments. Good if you want predictable, low-risk income.
  • Variable annuity — Investment-based; payouts depend on the performance of subaccounts (similar to mutual funds). May include riders for lifetime income at extra cost.
  • Fixed indexed annuity (FIA) — Credit is linked to an index (e.g., S&P 500) but typically has caps, participation rates, or spreads. It offers some upside with downside protection, but returns are limited by contract features.
  • Immediate annuity — Starts paying right away after purchase. Useful to convert a lump sum into a steady monthly income.
  • Deferred annuity — Accumulates value tax-deferred and begins payments later. Can be fixed, variable, or indexed.

How payouts are structured

Payouts can be:

  • Lifetime: Payments continue as long as the annuitant lives (removes longevity risk).
  • Period-certain: Payments for a fixed number of years.
  • Joint-and-survivor: Payments continue for the life of you and a spouse (often at a reduced amount after the first death).

Each structure balances income level against longevity protection and legacy goals.

Taxes and retirement accounts — what to know

Tax rules depend on whether the annuity sits inside a qualified account (IRA/401(k)) or is a nonqualified (after-tax) annuity:

  • Annuities inside IRAs or 401(k) plans follow the plan’s tax rules. Distributions are taxed as ordinary income if the underlying account was pre-tax; required minimum distributions (RMDs) apply where relevant (for traditional IRAs and certain employer plans) (IRS.gov).
  • Nonqualified annuities (bought with after-tax dollars) grow tax-deferred; when you take distributions, only the earnings portion is taxable. Withdrawals follow an exclusion ratio—part of each distribution is treated as a return of principal (non-taxable) and part as gain (taxable) until the basis is recovered (IRS guidance on annuities).
  • Early-withdrawal penalty: Distributions before age 59½ may trigger a 10% IRS penalty on taxable earnings, plus ordinary income tax, unless an exception applies (IRS.gov).

If you own an annuity inside a tax-qualified plan such as a 401(k), moving it to another retirement account may require careful rollover handling; see rollover rules and coordination with other retirement income sources (FinHelp guides on retirement accounts).

Fees, charges, and common contract features

Annuities can have several costs that reduce returns or flexibility:

  • Surrender charges: Early withdrawals above the free-withdrawal allowance may incur multi-year surrender fees.
  • Rider fees: Lifetime income riders or inflation riders cost extra and are often charged as a percentage of account value.
  • Mortality & expense (M&E) fees: Common on variable annuities, typically charged annually.
  • Underlying fund fees: Variable annuity subaccounts have fund expenses.
  • Caps/participation rates/spreads: For indexed annuities, these limit upside crediting.

Always ask insurers for an illustration and the contract’s prospectus or disclosure. In my practice I’ve seen clients accept higher rider fees without understanding that guaranteed income amounts were net of those fees — always run the net payout numbers.

Pros and cons — practical tradeoffs

Pros

  • Longevity protection: Lifetime payouts prevent outliving assets.
  • Predictable cash flow: Helps cover fixed expenses (housing, health care, insurance premiums).
  • Tax deferral: Earnings grow tax-deferred in nonqualified annuities.
  • Customizable benefits: Riders can add inflation protection, long-term-care credits, or joint survivorship.

Cons

  • Complexity: Contracts can be hard to compare across insurers.
  • Fees: Rider and fund fees can be substantial, especially on variable annuities.
  • Illiquidity: Surrender schedules limit access to capital in early years.
  • Inflation risk: Fixed payments can lose purchasing power without inflation protection.

When an annuity can make sense

Consider an annuity when:

  • You need predictable, paycheck-like income in retirement.
  • You worry about longevity risk and want a guaranteed lifetime stream.
  • Part of your portfolio is set aside for essential expenses and you want to reduce sequence-of-returns risk.

Annuities are not a universal solution. For many people, a blend of guaranteed sources (Social Security, pensions, annuities) and liquid investments works best. See FinHelp’s guidance on retirement account types and distribution strategies for planning context: “Retirement Account Types Explained: IRAs, 401(k)s, and More” and “Retirement Accumulation vs. Distribution: Different Mindsets.”

How to evaluate and compare annuity offers (step-by-step)

  1. Clarify the role: Do you want lifetime income, a legacy for beneficiaries, or tax-deferral?
  2. Compare guarantees, not just marketing slogans: Request a guaranteed income illustration under realistic assumptions.
  3. Review fees line-by-line: rider charges, M&E, fund expenses, and surrender schedules.
  4. Ask about inflation protection: Is there a cost to add a COLA or indexing feature?
  5. Check insurer strength: Look up insurer financial ratings (A.M. Best, S&P)—guarantees depend on the company’s claims-paying ability.
  6. Understand tax interplay: If inside an IRA/401(k), annuity tax benefits differ from nonqualified purchase.
  7. Consider timing: Delaying income start often increases payout levels; compare immediate vs deferred options.

In practice, I run Monte Carlo or cashflow models for clients to show how an annuity affects portfolio volatility and the probability of meeting spending goals.

Questions to ask a seller or advisor

  • What specific guarantees are included, and are they backed by the insurer or a third party?
  • What are all fees and surrender charges, and how long do surrender fees last?
  • How are returns credited (for FIAs) and what are the caps/participation rates?
  • Is there a lifetime income rider, and what does it cost?
  • How are beneficiaries treated on death? Are there death benefits?

Always get the contract in writing and consult an independent fiduciary if you can; commission-driven sales can bias product recommendations.

Common mistakes and misconceptions

  • Believing annuities are all the same. Variations in fees, guarantees, and indexing formulas create very different outcomes.
  • Ignoring the exclusion ratio on nonqualified annuities; only the gain portion is taxed when withdrawn.
  • Overpaying for riders that duplicate benefits you already have (e.g., long-term care coverage).

Short FAQ

Q: Are annuity payments taxable?
A: Yes—payments from pre-tax accounts (IRAs/401(k)s) are taxed as ordinary income. For nonqualified annuities, only the earnings portion is taxable when withdrawn (IRS guidance).

Q: Can I move an annuity into an IRA?
A: A nonqualified annuity cannot be rolled into an IRA without tax consequences. Annuities inside employer plans can sometimes be rolled to an IRA or another plan; follow rollover rules carefully.

Q: What about inflation?
A: Only annuities with cost-of-living riders or inflation-indexing will protect purchasing power; these typically reduce initial payout or add fees.

Professional disclaimer: This article is educational and does not constitute personalized tax, legal, or investment advice. Your financial situation differs from others; consult a qualified advisor or tax professional before buying an annuity.

Author note: In my 15+ years advising retirees, annuities have helped clients who needed a defined income floor. I also see many buyers who accept complex riders without quantifying net benefit—run the numbers first.

Authoritative references

Further reading on FinHelp