Annuities Explained: Fixed, Variable, Indexed and Income Annuities
An annuity is a contract with an insurance company that can turn savings into income, sometimes for life. This guide explains immediate and deferred annuities, fixed, variable and indexed designs, income riders, surrender charges, how payouts are taxed, who regulates them and what to ask before signing.
An annuity is a contract with an insurance company: the buyer hands over money, in one lump sum or over time, and the insurer promises something in return, whether a stated interest rate, a link to market performance, or income that can last for life. That last promise sets annuities apart from almost every other retirement product, and also makes them among the most complicated. This guide explains how the main types work, what they cost, how they are taxed and regulated, and what to ask before signing.
The basic mechanics
Every annuity has an owner (who controls the contract), an annuitant (whose life expectancy drives lifetime payments, often the same person) and a beneficiary. Contracts can be bought with ordinary savings or held inside an IRA or employer plan. Two questions define any annuity: when does income start, and how is the money credited while it waits?
Immediate vs. deferred
An immediate annuity, or single premium immediate annuity (SPIA), converts a lump sum into payments that begin shortly after purchase, such as a monthly check for life, with or without a guaranteed minimum period. The trade-off is liquidity: once payments begin, the lump sum is generally no longer accessible.
A deferred annuity has an accumulation phase first. The money grows on a tax-deferred basis for years, and the owner can later take withdrawals, annuitize the contract into payments, or leave it to beneficiaries. A deferred income annuity is a hybrid: a lump sum is paid today for lifetime income that starts at a chosen future age. Some versions can be held inside retirement accounts as a qualifying longevity annuity contract, with rules set by the IRS.
Fixed, variable and fixed indexed
How the money grows during deferral depends on the design.
- Fixed annuities credit a stated interest rate for a set period, somewhat like an insurer-issued CD. The insurer bears the investment risk.
- Variable annuities let the owner allocate money among subaccounts, which are investment portfolios similar to mutual funds. Value rises and falls with the markets, and the owner bears the investment risk. Because of that, variable annuities are securities as well as insurance products.
- Fixed indexed annuities credit interest based partly on the performance of a market index, such as a large-company stock index, without investing directly in it. Gains are limited by a cap, a participation rate or a spread, and losses are typically limited by a floor that prevents the credited rate from falling below zero. Index dividends are usually excluded. A related product, the registered index-linked (or buffered) annuity, accepts some losses in exchange for higher upside and is registered with the SEC.
| Feature | Fixed | Fixed indexed | Variable |
|---|---|---|---|
| How growth is credited | Declared interest rate | Formula tied to an index, with caps or participation rates | Performance of chosen subaccounts |
| Who bears market risk | Insurer | Mostly insurer; owner gives up upside | Owner |
| Principal loss from markets | No | Generally no, if held to term | Yes |
| Typical cost layers | Built into the rate; surrender charges | Built into the formula; surrender charges; rider fees | Mortality and expense charges, administrative fees, fund expenses, rider fees, surrender charges |
| Primary regulator | State insurance department | State insurance department | State insurance department plus SEC and FINRA |
| Complexity | Low | Medium to high | High |
Income riders and other add-ons
Many deferred annuities offer optional riders for an extra annual charge. The most common is a guaranteed lifetime withdrawal benefit, which lets the owner withdraw a set percentage of a separate "benefit base" each year for life, even if the actual account value falls to zero.
The benefit base is a frequent source of confusion. It is an accounting figure used to calculate income, not cash that can be withdrawn or left to heirs; a "roll-up" of the benefit base does not mean the account itself grows at that rate. Other riders cover enhanced death benefits, long-term care or inflation adjustments, each with its own cost.
Surrender charges, fees and liquidity
Most deferred annuities impose a surrender charge if more than a permitted amount is withdrawn during the first several years. The charge usually declines on a schedule until it disappears. Many contracts allow a limited penalty-free withdrawal each year.
Variable annuities typically carry more layers of cost: a mortality and expense risk charge, administrative fees, underlying fund expenses and rider charges. Fixed and indexed contracts often show no explicit annual fee, but the insurer's costs, including sales commissions, are reflected in the declared rate or the cap. The contract and, for variable annuities, the prospectus spell out every charge; Investor.gov and FINRA publish plain-language explainers.
Most states require a free-look period after delivery during which the buyer can cancel for a refund. Its length varies by state.
How annuity payouts are taxed, in general terms
The tax treatment turns on whether the annuity is qualified (held inside an IRA, 401(k) or similar account) or non-qualified (bought with after-tax money).
- Qualified annuities follow the rules of the account that holds them. Payments from a traditional IRA or 401(k) are generally fully taxable as ordinary income, and required minimum distributions apply. The annuity adds no extra tax deferral, since the account is already tax-deferred.
- Non-qualified annuities grow tax-deferred, but earnings are taxed as ordinary income, not at capital gains rates, when they come out. Withdrawals from a deferred contract are generally treated as coming from earnings first. Once a contract is annuitized, an exclusion ratio splits each payment into a tax-free return of principal and a taxable portion.
- Taxable withdrawals before age 59½ can trigger an additional 10% federal tax, subject to exceptions.
- Heirs who inherit a non-qualified annuity generally owe income tax on the gains; there is no step-up in basis as there can be with stocks or funds.
- A Section 1035 exchange allows one annuity to be swapped for another without immediate tax, although a new surrender period may start.
IRS Publication 575 covers the details. For how annuity income interacts with Social Security and other sources, see How Retirement Income Is Taxed.
Who regulates annuities
Annuities are insurance contracts, so state insurance departments license insurers and agents, approve products and handle complaints. Many states have adopted a best-interest standard for annuity sales based on a model regulation from the National Association of Insurance Commissioners.
Variable annuities and registered index-linked annuities are also securities. They must be registered with the SEC, come with a prospectus, and be sold by representatives of broker-dealers overseen by FINRA, which has a specific rule on recommending deferred variable annuities. Fixed and fixed indexed annuities are generally regulated as insurance only.
What happens if an insurer fails
Annuity guarantees are only as strong as the insurer behind them, and they are not FDIC-insured. Every state has a life and health insurance guaranty association, funded by insurers licensed there, that protects policyholders up to limits set by state law if a member company becomes insolvent. Coverage varies by state and product. Independent financial strength ratings and the state insurance department are the places to check an insurer's standing.
Trade-offs against other ways to fund retirement income
An annuity is one of several tools for turning savings into spending money. Each scenario carries different risks.
- Systematic withdrawals from a portfolio keep money liquid and inheritable, but leave the retiree exposed to market losses and to outliving the money. Our guide to the 4% rule and withdrawal rates explores that approach.
- Bond or CD ladders offer predictable cash flows for a fixed number of years, but stop when the ladder ends.
- Delaying Social Security raises an inflation-adjusted lifetime benefit, which works like buying a government-backed annuity.
- A lifetime annuity pools longevity risk: people who live longer are subsidized by those who die earlier. The cost is lost liquidity, payments that may not keep up with inflation unless a rider is purchased, and dependence on one insurer.
Retirees often combine approaches, covering essential expenses with guaranteed income and leaving the rest invested.
Questions to ask before signing
- Is this a fixed, fixed indexed, variable or registered index-linked annuity, and who regulates it?
- What is the surrender charge schedule, and how much can be withdrawn each year without a penalty?
- What are all the annual charges, including rider fees, in dollars as well as percentages?
- For an indexed product, what are the current cap, participation rate or spread, and can the insurer change them at renewal?
- Is the benefit base real money, or only a figure used to calculate income?
- How will payments be taxed, given whether the money is qualified or non-qualified?
- What is the insurer's financial strength rating, and what does the state guaranty association cover?
- How is the seller paid, and is the agent or representative licensed in this state? State insurance departments and FINRA BrokerCheck can confirm that.
- How long is the free-look period?
Annuities can address a real problem, the risk of running out of money, but the contract terms decide whether a particular product does that efficiently.
This article is for general information and education only and is not financial, investment, tax or legal advice. Rates, caps, fees and guaranty limits change and vary by state; confirm current details with the insurer, your state insurance department, the SEC and FINRA.
Frequently asked questions
What is the difference between an immediate and a deferred annuity?
An immediate annuity starts paying income shortly after a single lump-sum purchase, usually within a year. A deferred annuity has an accumulation phase first, during which the money grows on a tax-deferred basis, and income or withdrawals come later. Many deferred contracts can be converted into a stream of payments at a future date.
Are annuities protected if the insurance company fails?
Annuities are not covered by the FDIC or by SIPC in the way bank deposits and brokerage accounts are. Each state has a life and health insurance guaranty association that steps in when a member insurer becomes insolvent, up to limits set by state law. The limits and rules differ by state, so the state insurance department is the place to confirm current coverage.
How are annuity payments taxed?
It depends on how the annuity was funded. If it sits inside a traditional IRA or 401(k), payments are generally taxed as ordinary income because the contributions were never taxed. If it was bought with after-tax money, part of each annuitized payment is treated as a tax-free return of principal and the rest as taxable earnings, and withdrawals from a deferred contract are generally taxed earnings first.
