Annuities in Retirement: Pros, Cons, and When They Fit

How annuities provide retirement income

Annuities are contracts sold by insurance companies that turn capital into scheduled payments. They’re most useful when you need dependable cash flow in retirement or want to manage longevity risk (the chance of outliving your savings). In my 15+ years advising retirees, I’ve used annuities selectively to create a base layer of guaranteed income while keeping other assets invested for growth and liquidity.

Below is a practical guide to the pros, cons, types, tax treatment, and how to decide if an annuity belongs in your plan.

How annuities work (simple mechanics)

• You fund the annuity with either a lump sum (single premium) or ongoing premiums.
• The insurance company invests and, in return, promises future payouts according to the contract terms.
• Payouts can start immediately (immediate annuity) or be deferred to a future date (deferred annuity).
• Payouts can be fixed, variable (linked to underlying funds), or indexed (tied to an index with caps/floors).

Key trade-offs are liquidity (many annuities have surrender charges and limited access), fees (rider and fund costs), and counterparty risk (reliability depends on the insurer’s financial strength).

Common annuity types (and when each fits)

• Fixed immediate annuity: Convert a lump sum into guaranteed monthly checks for life or a set period. Good if you want certainty and are less concerned about inflation.
• Deferred fixed annuity: Accumulates at a stated interest rate, then begins payouts later—useful for locking in rates when yields look attractive.
• Variable annuity: Investments are in subaccounts similar to mutual funds. Potential for higher returns but with market risk and higher fees.
• Indexed (equity-indexed) annuity: Credits interest based on an index’s performance with limits; offers limited upside and downside protection.
• Qualified Longevity Annuity Contract (QLAC): A special deferred annuity bought inside an IRA/401(k) to delay required minimum distributions (RMDs) and provide income starting later in retirement. The IRS allows QLACs up to $200,000 per owner (or 25% of the account balance, if smaller) and can defer RMDs until age 85 (IRS guidance). See the FinHelp guide to QLACs for details: https://finhelp.io/glossary/qualified-longevity-annuity-contract-qlac/

For practical strategies, many advisors use a mix—often a guaranteed base income from annuities plus a growth portfolio. You can explore payout structures in our explainer on payout options: https://finhelp.io/glossary/exploring-annuity-payout-options/.

Pros: What annuities do well

• Guaranteed income for life (longevity protection): Eliminates or reduces the risk you’ll run out of money.
• Predictable budgeting: Fixed or guaranteed streams make monthly planning easier.
• Tax-deferred growth (for non-qualified annuities): Earnings grow tax-deferred until withdrawn.
• Optional guarantees and riders: Income and death-benefit riders can be added for extra protection (at a cost).
• Legacy options: Some annuities offer death benefits to beneficiaries.

Cons: What to watch out for

• Fees and rider costs: Variable annuities and riders (income guarantees, living benefits) can carry material fees.
• Surrender charges and limited liquidity: Early withdrawals can trigger high charges—see our page on surrender charges: https://finhelp.io/glossary/annuity-surrender-charge/.
• Counterparty risk: Guarantees are only as strong as the insurer; state guaranty associations provide limited backstops but limits vary by state.
• Inflation risk: Fixed payouts lose purchasing power over time unless the annuity or rider includes inflation adjustments.
• Tax treatment for non-qualified annuities: Earnings are taxed as ordinary income; the exclusion ratio or LIFO rules can apply, complicating planning.

Tax basics and required minimum distributions (RMDs)

• Non‑qualified annuities (bought with after‑tax dollars): Earnings grow tax‑deferred. Withdrawals are taxed on the gain portion; the basis (premiums paid) is returned tax‑free. For certain payout forms—like lifetime immediate annuities—an exclusion ratio may apply to portion out return of basis vs. earnings.
• Qualified annuities (inside IRAs/401(k)s): Distributions are generally fully taxable as ordinary income because contributions were tax‑deferred.
• Early withdrawal penalty: Distributions before age 59½ may be subject to the 10% early withdrawal penalty in addition to income tax, unless an exception applies.
• QLACs: Purchasing a QLAC inside a retirement account can delay RMDs until age 85, helping manage RMD timing (IRS rules; current limit $200,000 per owner).

Always confirm current tax rules with the IRS and your tax advisor (IRS: https://www.irs.gov; Consumer Financial Protection Bureau: https://www.consumerfinance.gov).

Who should consider an annuity?

An annuity can be appropriate if you:

• Want a predictable baseline of income to cover essentials (housing, health care, living expenses).
• Are concerned about longevity risk and want to ensure you don’t outlive your savings.
• Prefer shifting some market risk to an insurer in exchange for guaranteed paychecks.
• Have other liquid savings to cover emergencies and short-term needs, because annuities are often illiquid.

In contrast, avoid locking a large portion of your nest egg into an annuity if you expect substantial near-term liquidity needs, want full legacy flexibility, or if fees erode the value proposition.

Practical strategies I use with clients

• Partial allocation for base income: Convert 20–40% of safe assets into a lifetime income annuity for essentials, leaving remaining assets invested for growth and flexibility.
• Laddering annuities: Stagger purchases or start dates to capture different rates and maintain flexibility; see our annuity laddering guide for methods and examples: https://finhelp.io/glossary/annuity-laddering/.
• Using QLACs selectively: For clients who want to delay RMDs or guarantee late-life income, a QLAC can be a cost-effective choice—check the $200,000 limit and plan RMD timing with your tax advisor.
• Balancing inflation: Consider indexed annuities with participation rates or riders that include cost-of-living adjustments, or add a small allocation to TIPS or inflation-protected bonds.

In my practice, a retiree who feared market volatility often benefited most from a blended approach: a fixed immediate annuity to secure essential expenses plus a diversified investment portfolio for discretionary spending and legacy goals.

Common mistakes and how to avoid them

• Buying an annuity as a single-solution: Annuities are tools, not entire plans. Pair them with liquid buffers and diversified investments.
• Overlooking fees: Ask for a full fee schedule, including mortality and expense fees for variable products, administrative fees, and rider costs.
• Ignoring surrender periods: Understand how long you’ll be locked in and the penalties for withdrawals.
• Not checking insurer strength: Review insurer financial ratings (A.M. Best, S&P, Moody’s) and state guaranty limits.
• Failing to model taxes: Run after‑tax income scenarios—annuity payouts can change effective tax rates in retirement.

How to evaluate a specific annuity offer

1. Identify type (fixed, variable, indexed, immediate, deferred, QLAC).
2. Confirm payout schedule, guaranteed period, and whether payments are for life or a term.
3. Request a full illustration showing fees, rider costs, projected payouts under conservative and optimistic scenarios, and surrender schedule.
4. Compare the insurer’s financial strength and the state guaranty association limits where you live.
5. Run an after‑tax cash‑flow comparison against alternatives like a bond ladder, cash annuities, or systematic withdrawals from a taxable or tax‑deferred account.

If you want a practical checklist, our article on buying timing and questions covers sales tactics and due diligence: https://finhelp.io/glossary/when-to-buy-an-annuity-questions-to-ask-before-you-commit/.

Examples (illustrative)

• Immediate annuity example: A 65‑year‑old buys a fixed immediate annuity with $100,000 and receives a guaranteed monthly payment. The payment level depends on the insurer’s rates, the annuitant’s age, and whether payments are single life or joint life with survivor benefits.
• Deferred example: A 55‑year‑old places $50,000 into a deferred fixed annuity to begin payouts at 70. The annuity grows at a stated crediting rate, and payouts are based on accumulated value at annuitization.

Note: Illustrations above are simplified. Actual payouts require contract specifics and insurer quotations.

Next steps and resources

• Get a written illustration and compare at least two insurers.
• Ask for transparency on all fees and surrender terms.
• Consult a fee‑only financial planner or a qualified financial adviser who is fiduciary bound to act in your best interest.

Authoritative references: IRS guidance on retirement accounts and QLACs (IRS.gov), Consumer Financial Protection Bureau guidance on annuity sales and complaints (consumerfinance.gov), and state guaranty association pages for insurer protections. These sources provide rule updates and consumer protection details—always verify current limits and rules before you buy.

Professional disclaimer

This article is educational and does not provide personalized financial, tax, or legal advice. Your situation may warrant different choices. Consult a certified financial planner, tax professional, or attorney who can review your full financial picture before purchasing an annuity.