Annuities explained: types, tax rules, and how income payments work

Most annuities move through two phases. In the accumulation phase, your deposit grows at a fixed rate, by tracking a market index, or through direct market participation, depending on the product type. In the distribution phase, the insurer pays out according to a schedule you selected, which might be a fixed term of years, your lifetime, or your lifetime plus your spouse's lifetime.

The contract structure also introduces features a brokerage account does not carry: mortality and expense charges, surrender periods during which early withdrawals trigger a fee, and optional riders that add income guarantees or death benefits for an annual cost.

In short: an annuity is a legally binding promise from an insurer to pay income, backed by the insurer's assets and state guaranty protections.

The three broad categories differ in how your money grows during accumulation and how much market risk you carry.

Fixed annuities credit a declared interest rate set by the insurer, similar in concept to a certificate of deposit. The rate is locked for a specified period, after which the insurer may reset it. Your principal is not exposed to market loss. Fixed annuities suit people who want predictable, low-risk accumulation.

Variable annuities place your premium into subaccounts that function like mutual funds. Returns rise and fall with the market. Over long time horizons, variable annuities have historically offered higher growth potential than fixed products, but you carry the investment risk directly. The SEC and FINRA regulate variable annuities as securities in addition to the state-level insurance regulation that governs all annuities.

Fixed-indexed annuities (FIAs) link interest crediting to the performance of a market index, such as the S&P 500, but cap your upside and protect your downside with a floor, usually set at 0%. A participation rate determines what fraction of the index's gain you receive. FIAs occupy the middle ground between fixed and variable products on the risk-reward spectrum.

Beyond these three, immediate annuities begin paying income within roughly a month of purchase, while deferred annuities accumulate for years before income starts. A multi-year guaranteed annuity (MYGA) is a type of fixed annuity that locks in a rate for a defined term, from two to ten or more years.

In short: fixed annuities offer stable insurer-set rates, variable annuities follow market subaccounts, and fixed-indexed annuities track an index with a downside floor.

When you fund a deferred annuity, your money grows inside the contract according to the product type. One consistent feature across nearly all annuities is tax deferral on growth: you do not owe income tax on credited interest or investment gains until you take a distribution. For a non-qualified annuity (funded with after-tax dollars), only the earnings portion is taxable at distribution; your original premium comes back to you free of income tax because you already paid tax on it before depositing.

Surrender charges apply in most deferred annuities during an initial period that may last from three to ten or more years, depending on the contract. If you withdraw more than the penalty-free amount (contracts typically allow withdrawals of a percentage of the account value each year without a charge), the insurer deducts a surrender charge from the amount withdrawn. Surrender charges protect the insurer's ability to invest long-term and are a meaningful factor when comparing contracts.

Riders attached during accumulation can add features for an annual fee, including guaranteed minimum accumulation benefits (GMABs), which promise your contract value will not fall below a set floor after a specified period, and guaranteed minimum income benefits (GMIBs), which guarantee a minimum income base for calculating future withdrawals regardless of account performance.

In short: tax deferral is the core accumulation advantage of an annuity, but surrender charges and rider fees reduce net growth and deserve careful comparison before you sign.

Annuitization converts your contract value into a payment stream according to one of several payout options. The insurer calculates payments using your account value, your age, the prevailing interest rate environment, and the option you select at the time of annuitization.

Common payout structures include:

• Life only: the highest periodic payment because the insurer stops paying when you die, even if that happens shortly after annuitization begins.
• Life with period certain: payments continue for your lifetime, and if you die before the period ends (often ten or twenty years), a beneficiary receives the remainder of the guaranteed payments.
• Joint and survivor: covers two lives, typically spouses, with payments continuing until both have died, often at a reduced level after the first death.
• Period certain only: payments run for a fixed number of years regardless of whether you survive the full term.

Systematic withdrawal strategies offer an alternative to formal annuitization. Instead of converting the contract to a fixed income stream, you take scheduled withdrawals from the account value. If the account is depleted before you die, payments stop, unlike a lifetime annuitization option.

Guaranteed lifetime withdrawal benefits (GLWBs) bridge these two approaches. Under a GLWB rider, you draw a specified percentage of an income base each year for life, even if the underlying account value falls to zero. The insurer backstops any shortfall. These riders carry an annual fee, and the income base they reference may differ significantly from the actual contract value.

In short: choosing a payout option means trading payment size against survivor protection and income certainty, so consider your household's longevity and income picture before locking in.

Tax rules for annuities depend primarily on whether the contract is qualified or non-qualified.

Qualified annuities are held inside a retirement account such as a traditional IRA or 401(k). Contributions were made with pre-tax dollars, so every dollar of distribution, including the original principal, is taxable as ordinary income in the year received.

Non-qualified annuities are purchased with after-tax money. The IRS uses an exclusion ratio to determine how much of each payment is a tax-free return of your cost basis and how much is taxable earnings. Once you have fully recovered your cost basis, subsequent payments become entirely taxable.

In both cases, the IRS treats annuity income as ordinary income rather than capital gains. That means distributions are taxed at your marginal income tax rate, which may exceed the long-term capital gains rate that would apply to the same assets in a taxable brokerage account. This comparison is one reason annuities tend to be more advantageous for people who expect to be in a lower tax bracket during retirement than during their working years.

Early withdrawals, defined by the IRS as distributions before age 59½, are subject to a 10% additional tax on the taxable portion of the distribution in addition to ordinary income tax, unless an exception applies. Per IRS Publication 575, exceptions include distributions made as part of a series of substantially equal periodic payments, distributions following disability or death, and certain other qualifying events.

In short: qualified annuity distributions are fully taxable as ordinary income; non-qualified distributions are partly taxable via the exclusion ratio; and withdrawals before 59½ carry a 10% federal penalty unless an IRS exception applies.

Annuity pricing is less transparent than stock prices, but several factors consistently shape what you receive and what you pay.

Interest rates are the largest external variable. Insurers invest premiums largely in bonds, so rising rates generally improve fixed annuity payouts and the income base growth credited under GLWB riders. Variable annuity annuitization rates also reflect the interest environment at the time of conversion.

Your age and health determine the insurer's mortality assumption. Older applicants typically receive higher income payments per dollar deposited because the insurer expects fewer payments over a shorter period. Some annuities offer enhanced payout rates for applicants with qualifying health conditions, a feature called medically underwritten or impaired-risk annuities.

Contract features and riders add cost. A GLWB rider, a death benefit enhancement, or an inflation-adjustment feature each carry annual fees that reduce net growth. Reading the fee disclosure summary in the contract, required under NAIC model regulation, shows the all-in cost before you commit.

Surrender charge schedules affect your access to principal. A longer surrender period often comes with higher initial credited rates or bonus credits, but it ties up your money. If you anticipate needing access to principal within a few years of purchase, a product with a short or no surrender period may serve you better even if the initial rate is lower.

Issuer financial strength matters because your payout depends on the insurer's ability to pay obligations decades from now. State guaranty associations provide a financial backstop, but coverage limits vary by state. Checking an insurer's financial strength rating from agencies such as AM Best, Moody's, or S&P before purchasing is a standard step.

In short: interest rates, your age, rider fees, and issuer financial strength all shape what an annuity pays and costs, so comparing contracts across each dimension is essential.

Annuities and life insurance address opposite ends of longevity risk: life insurance pays a benefit when you die too soon, while an annuity pays a benefit when you live longer than expected. Together they cover the full range of financial risk tied to how long you live.

Many permanent life insurance policies, particularly whole life and universal life products, accumulate cash value that can be accessed during your lifetime, giving them functional overlap with deferred annuities. But life insurance's primary purpose is the death benefit, and annuities' primary purpose is living income. Choosing between them on the basis of the secondary feature rather than the primary one usually leads to a mismatch.

According to ACLI data, $22.0 trillion of life insurance was in force in the US at year-end 2024. Among new individual policies sold that year, permanent products carried 72.1% of the total face amount sold, even though term policies accounted for the majority of policies by count. That concentration of face amount in long-duration permanent products reflects the same extended planning horizon that makes annuities useful for retirement income: both products are built around the assumption that you are planning for decades, not years.

A practical tax note when holding both product types: life insurance death benefits pass to beneficiaries income-tax-free in most cases, while annuity death benefits paid to beneficiaries are taxable on the earnings portion. This asymmetry sometimes influences how people allocate assets across the two product types within a broader estate plan, favoring the life insurance side for assets intended to pass at death.

In short: life insurance and annuities address opposite longevity risks and often complement each other in a retirement plan, but their tax treatment at death differs in ways that affect how beneficiaries receive the money.