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How Do Annuities Work? A Beginner’s Guide

Written by JD Esajian

If you are looking for more information about annuities and are confused about what they are, this guide can help. Unless you’re a millionaire, you need to ensure you have enough wealth-building tools to get you through retirement and the later part of your life.

Different types of annuities can ensure that you are putting together all the pieces of your retirement puzzle. Knowing the basics of annuities can ensure you have everything you need to plan for the future. So how do annuities work?

What Are Annuities?

Before you can know how annuities work, you need to know what they are. This will help guide you in your financial decisions when you know what to buy or how to plan. An annuity is a financial retirement tool that is a contract between you and an insurance company.

There are two different ways you can buy an annuity. One is to make a lump sum payment, and the other is by paying into it on a set schedule, such as monthly or quarterly. As you give money to the insurance company, they will invest it. However, this investment is usually lower than the investments you would get from stocks or bonds.

So, any contract between you and an insurance company that requires you to make payments to them is considered an annuity. Just as you can pay as a lump sum or in installments, your payout can also be in one payment or smaller installments.

People buy annuities for many different reasons. Some of the main ones include:

  • Tax-deferred growth: This is when you don’t pay taxes on the income and the investment gains until you withdraw the money.

  • Death benefits. If you pass away before receiving the annuity payments, the person who is named as the beneficiary will receive the payments instead.

  • Periodic payments. You can opt to get periodic payments for a set amount of time, either for the rest of your life or the life of the beneficiary.

There are many different annuities you can choose to invest in, and some can even be customized to fit your exact needs.

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what is an annuity

Types Of Annuities

There are three different types of annuities you can choose from: fixed annuities, indexed annuities, and variable annuities. Before you get an annuity, you need to make sure you understand the different types and fees.

Fixed Annuities

A fixed annuity is one of the most straightforward types you will encounter. The insurance company will give you a set interest rate, and it will be locked in. This means your interest rate will not be affected by market rates.

Many people like fixed annuities because they will be able to know exactly how much their payoff amount will be.

Before getting fixed annuities, make sure you check with the state insurance commission about the benefits and risks of fixed annuities. You also need to make sure the insurance broker is registered to sell the insurance in your state.

Here is some more information about the different kinds of fixed annuities:

  • Deferred income annuities mean that the income stream is deferred. This means your income can start from months to years after you have initially purchased the annuity. The time from the day you purchased it to the time they start paying is the accumulation period. You can also make extra payments during the accumulation periods to see if your future income will increase.

  • Immediate fixed-income annuities mean that you need to pay a lump sum to get a stream of income for a set period of time. This can extend over the course of your life or whatever the contract might state. These payments usually begin immediately.

Variable Annuities

Variable annuities are different and can be hard to understand. They’re more of an investment since your payments will depend on the return of the investments that you choose for the annuity. This means you need to choose your investments wisely.

Variable annuities can give you a higher return, or they can give you a lower-than-expected income in retirement, depending on what you chose to invest in. The payout rates of variable annuities depend on the performance of your investment portfolio.

The variable annuities are riskier, but they might give you more of a payout depending on the investments you made and their growth potential.

When you choose variable annuities, you can choose to put your annuity payments into a number of different investment options, including mutual funds. The payout will depend on how much money you put into the investments. The SEC will regulate all variable annuities.

Indexed Annuities

An indexed annuity is a type of annuity that combines the features of insurance products and securities. The insurance company will credit you when there is a return based on the stock market index. These types of indexes are always regulated by the state insurance commissioner.

Indexed annuities are basically a mix of fixed and variable annuities. Indexed annuities can protect you from drops in the market, but this also means you won’t be able to benefit as much when the market rises. You will be able to get a base amount of income, and then you might be able to get more if the investment you chose is going up in market value.

Variable Annuity Fees

There are several fees you will be in charge of paying when it comes to investing in a variable annuity. You need to make sure you know all these charges before you invest, as they can help you prepare for the fees you need to pay:

  • Penalties. There are penalty charges you will need to pay if you withdraw the money before you turn 59 and a half. This usually involves a 10% tax penalty that you will need to pay to the IRS on top of the taxes you will need to owe for income.

  • Administrative fees. This often involves charges for record keeping. They are a flat annual fee or a percentage of the account value, depending on the insurance company you are using.

  • Fund expenses. You will also need to pay fees and expenses for the mutual fund investments.

  • Mortality and expense risk charge. This charge will be equal to a certain percentage of the account value. It’s usually around 1.25% per year. This charge will pay the issuer for the insurance risk. The profit from the charge might be used to pay a commission to the person who originally sold the annuity.

  • Other fees. You might have to pay fees for things like special features, initial sales loads, or fees for transferring part of the account to another investment account you have.

How To Buy & Sell Annuities

Insurance companies are the main source of annuities, but some banks also sell them. No matter where you choose to buy an annuity, make sure the terms and conditions are properly stated, and ask any questions you have before signing.

You also want to know everything you can about the mutual fund prospectus. This will give you more information on where you should allocate your money and where you should focus more on your investments.

If you sell or withdraw money too early from variable annuities, you risk getting a surrender charge. This usually applies if you take money out within the first 6 to 8 years of owning the annuity.

Surrender charges also reduce the value of the investment, so make sure you try not to do this unless really necessary.

If you’re investing in a 401k or an IRA, you will not get any additional tax advantages from a variable annuity. You should only get variable annuities when you are able to get more features from the fact that it’s variable and not fixed.

Annuities Vs. A 401(k)

Annuities are still a type of 401(k), but they work very differently, and they have some major advantages. Here are some of the main differences:

  • Tax deferrals. Contributions made to 401ks allow for tax deductions on the year you made them. You cannot deduct taxes from the annuities.

  • Taxes on withdrawals. Withdrawals on 401ks are taxable in the entire amount while only portions of the annuity are taxable.

  • Contribution limits. There are limits for 401ks but not for annuities. The limit changes every year.

  • Availability. 401k plans are only available when the employers offer them but annuities are not sponsored by anyone.

Pros & Cons Of Annuities

Many people like to use annuities to make sure they are saving enough money for retirement. All investments carry some risks, though, so it’s important to be aware of them before diving in and getting annuities.

Some people think the disadvantages outweigh the risks of the benefits, but you should decide for yourself.

Advantages Of Annuities

You don’t want to run out of money in retirement. This is one of the reasons why people look to use annuities you want to make sure you have enough money to last you for the rest of your life. Having an annuity means you get a monthly payment for the rest of your life. It can definitely give you peace of mind when it comes to retirement.

You just need to make sure the annuity can cover your expenses during retirement. While this might seem like a good option, there are some real downsides to keep in mind that you shouldn’t dismiss.

Disadvantages Of Annuities

Once you have the money into the annuity, it’s extremely hard to get it back out. This means the money is out of your hands until the payments start. They also have high fees, which can make you confused and take away a lot of the money you’re putting into the investment.

Not everyone should get an annuity. You might be able to earn a higher ROI if you invest your money elsewhere, so you should consider all investment options.

Are Annuities A Good Investment?

Annuities are good for healthy older people who want to save for retirement and who do not need money right away for medical bills. Younger people might want to choose to invest their money in other things like stocks to make more money.

Annuities are a relatively safe investment, though, as long as you purchase them from well-established companies. You want to make sure your money is well protected.


If you were banging your head against the wall saying “how do annuities work” Annuities are money that you invest with an insurance company that can help you save for retirement by giving you an extra monthly payment after you have retired. Just make sure you choose a reputable company and know the terms and conditions.

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