Elaine Silvestrini, Annuity.org Writer
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    Elaine Silvestrini

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    Elaine Silvestrini is an advocate for financial literacy who worked for more than 25 years in journalism before joining Annuity.org as a financial writer.

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    Emily Miller, Managing Editor for Annuity.org

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  • Updated: September 12, 2022
  • This page features 5 Cited Research Articles
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APA Silvestrini, E. (2022, September 12). How Do Annuities Work? Annuity.org. Retrieved September 22, 2022, from https://www.annuity.org/annuities/how-they-work/

MLA Silvestrini, Elaine. "How Do Annuities Work?" Annuity.org, 12 Sep 2022, https://www.annuity.org/annuities/how-they-work/.

Chicago Silvestrini, Elaine. "How Do Annuities Work?" Annuity.org. Last modified September 12, 2022. https://www.annuity.org/annuities/how-they-work/.

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Annuities are insurance products that provide a reliable, steady stream of payments to support your financial needs for the rest of your life or for a pre-determined number of years.

Pro Tip
Because they are contracts, annuities can also be adapted to meet your specific needs and fit your comfort with different levels of risk.

You can get a fixed annuity in which the payments are spelled out exactly ahead of time in the contract. Or you can get a variable annuity with the potential for higher – or lower – payments, depending on the performance of a traditional investment portfolio.

Annuities are not for everyone. But if you’re nearing retirement and need to ensure you can pay your living expenses after you’ve stopped working, you should consider if an annuity is right for you.

Wendy Swanson, Retirement Income Certified Professional™, explains how you can use an annuity for guaranteed income.

Annuities Explained

An annuity is an insurance contract between you and a provider company in which you purchase a stream of payments to yourself over time to protect against outliving your income.

There are a number of annuity types, allowing you to find which one fits your needs and comfort level. You can also purchase a variety of contract provisions, known as riders, to modify the annuity to further customize it.

How Do Fixed Annuities Work?

Fixed annuities work by providing periodic payments of steady income in the amount specified in the contract. If your contract says the payout rate is 5% on a $100,000 annuity, for example, then you will receive $5,000 worth of payments every year covered by the contract.

how Fixed Annuities work
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How Does a Variable Annuity Work?

Variable annuities have payout rates that vary, depending on the performance of an investment portfolio. The amount you receive in payments depends on how much money the portfolio gains or loses. This is riskier, but also has the potential of paying you more.

how Variable Annuities work
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What is your goal for purchasing an annuity?

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Are Annuities a Good Idea?

Whether annuities are a good idea depends on your circumstances, your needs and whether the particular annuity type is a good fit.

If you already have a healthy pension or another source of income sufficient to support your everyday needs in retirement, you may not need an annuity.

If you don’t have a guaranteed stream of retirement income, you should consider buying an annuity. An annuity is a good source of lifetime income.

Who Should Consider Annuities?

If you’re healthy and likely to live a long life, an annuity can be good insurance against outliving your savings.

If you’re unhealthy, annuities might not work for you. This is especially true if you don’t expect to live long and are unlikely to outlive your savings. You also may need access to your savings to pay medical bills.

If you’re younger, you’re likely to be able to invest in stocks and other offerings that are more risky because you have time to recover losses in the long run. If you’re older, the safety and predictability of annuities are likely to be more suited to your needs.

The good thing about considering annuities is that many of them offer a free look period that gives you time to consider the contract and make sure it is the right choice for your life.

Are Annuities Safe?

By and large, annuities are a safe investment. However, it’s important with annuities to purchase them from highly rated, well-established insurance and financial services companies with good reputations.

That’s partly because, unlike certificates of deposit, annuities are not insured by the Federal Deposit Insurance Corporation.

Pro Tip
All states have guaranty associations that insure at least partially against the failure of annuity providers.

The amount of protection varies from state to state. States also regulate insurance companies, requiring them to meet financial standards intended to keep them solvent.

All insurers that sell annuities must belong to the guaranty associations in the states where they operate. For information about your state’s guaranty association, you can find links to all state associations on the website of the National Organization of Life & Health Insurance Guaranty Associations.

Ways Annuity Investments Are Safer

In two states — Florida and Texas — your money in an annuity is protected from creditors and frivolous lawsuits. Most other states provide limited protections. And likewise, in federal bankruptcy cases, the law provides a small amount of protection of annuity assets from creditors.

Pro Tip
Investing in a fixed annuity, as opposed to the stock market, protects your money from the overall economic threats that can diminish your nest egg in the short term, said Wenliang Hou, quantative analyst at Fidelity Investments.

This is especially important for older people depending on their savings who cannot afford to ride out a down market.

Annuity vs. 401(k)

Annuities and 401(k) plans are retirement accounts with some significant differences.

Here are some of those differences:
Availability
401(k) plans are available only to individuals whose employers offer them. Annuities are not employer-sponsored and can be purchased by anyone.
Contribution limits
There are contribution limits for 401(k) accounts, but none for annuities. As of 2022, the annual 401(k) contribution limit was $20,500.
Tax deferrals
Both annuities and 401(k) accounts provide the ability to defer paying taxes on earnings until the money is withdrawn. However, contributions to 401(k) accounts may be deducted from your taxes in the years in which they are made. Contributions to annuities may not be tax deducted.
Taxes on withdrawals
Because of that 401(k) deduction, withdrawals from those accounts are taxable in their entirety. Only the portions of annuity withdrawals that represent earnings are taxable.

Some people chose to roll all or part of their 401(k) savings into annuities as a means of providing a stream of income to fund retirement.

The Setting Every Community Up For Retirement Enhancement (SECURE) Act, which was passed into law in December 2019, gives employers greater leeway to include annuities in their workplace-sponsored retirement plans.

How Much Do You Need to Start an Annuity?

Each annuity has different fees and restrictions. Different companies set different investing requirements.

But in deciding whether you have enough money to invest in an annuity, it may be best to consider what kind of return your annuity purchase might bring.

Let’s take a fixed, immediate annuity with a 5% payout rate as an example. That means, each year, you will receive payments totaling an amount equivalent to 5% of your investment.

Fixed Annuity Purchase at 5% Yearly Payment Monthly Payment
$1,000 $50 $4.71
$5,000 $250 $20.83
$10,000 $500 $41.66
$25,000 $1,250 $41.66
$50,000 $2,500 $208.33
$100,000 $5,000 $416.67
$500,000 $25,000 $2,083.33

You should decide if the money you can spend on an annuity will bring you enough income to make having the annuity worthwhile.

Please seek the advice of a qualified professional before making financial decisions.
Last Modified: September 12, 2022

5 Cited Research Articles

Annuity.org writers adhere to strict sourcing guidelines and use only credible sources of information, including authoritative financial publications, academic organizations, peer-reviewed journals, highly regarded nonprofit organizations, government reports, court records and interviews with qualified experts. You can read more about our commitment to accuracy, fairness and transparency in our editorial guidelines.

  1. Haithcock, S. (2013, October 8). How annuities can shield you from creditors. Retrieved from https://www.marketwatch.com/story/how-annuities-can-shield-you-from-creditors-2013-10-08
  2. Money. (n.d.) Should I Roll My 401(k) Into an Annuity? Retrieved from https://money.com/collection-post/should-i-roll-my-401k-into-an-annuity/
  3. National Organization of Life & Health Insurance Guaranty Associations. (n.d.). Policyholder Information. Retrieved from https://www.nolhga.com/policyholderinfo/main.cfm
  4. Rodeck, D. (n.d.). What Is the Difference Between Annuities & 401(k) Plans? Retrieved from https://budgeting.thenest.com/difference-between-annuities-401k-plans-25970.html
  5. U.S. Internal Revenue Service. (2021, November 17). IRS announces changes to retirement plans for 2022. Retrieved from https://www.irs.gov/newsroom/irs-announces-changes-to-retirement-plans-for-2022