What Is an Annuity? Types, Pros, Cons Explained Simply

One of the biggest fears in retirement is running out of money. Social Security helps, but for many people it is not enough to cover all expenses. Pensions are increasingly rare. That is where annuities come in. An annuity is a contract with an insurance company designed to provide you with a guaranteed income stream, either for a set period or for the rest of your life.

Annuity sales in the United States have surged in recent years, with 2026 sales projected to exceed $450 billion according to industry data from LIMRA. Rising interest rates have made annuities more attractive, offering competitive guaranteed rates. But annuities are complex financial products with important trade-offs. This guide explains how annuities work, the different types available, and the pros and cons you should understand before buying one.

This article is for educational purposes only and does not constitute investment advice. Consult a qualified financial advisor before making any decisions about annuities or other financial products.

What Is an Annuity?

An annuity is a contract between you and an insurance company. You pay the insurance company money, either as a single lump sum or through a series of payments over time. In return, the insurance company agrees to make periodic payments to you, starting either immediately or at a future date you choose.

The fundamental purpose of an annuity is to convert a pool of savings into a predictable income stream. Unlike a bank account or brokerage account where you decide how much to withdraw each month, an annuity can guarantee payments for as long as you live. This protection against outliving your money is called longevity risk protection, and it is the primary reason people buy annuities.

Annuities are issued by life insurance companies, not banks or brokerage firms. They are regulated primarily by state insurance departments. Variable annuities, which involve investment in securities, are also regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).

How Annuities Work: The Two Phases

Every annuity has two phases: the accumulation phase and the distribution phase (also called the annuitization phase).

Accumulation phase. This is the period when you are putting money into the annuity. Your funds grow on a tax-deferred basis, meaning you do not pay taxes on any gains until you withdraw money. With a fixed annuity, your money grows at a guaranteed interest rate. With a variable annuity, your money is invested in sub-accounts and grows or shrinks based on market performance. With an indexed annuity, your growth is tied to the performance of a market index, subject to caps and floors.

Distribution phase. This is when the insurance company starts paying you. You can receive payments for a set number of years (period certain), for the rest of your life (life annuity), or for the lives of you and your spouse (joint-and-survivor annuity). The payment amount depends on how much you contributed, the type of annuity, your age when payments begin, and the payout option you select.

With an immediate annuity, the accumulation phase is essentially skipped. You make a single lump-sum payment, and income payments begin within 30 days. With a deferred annuity, you allow your money to grow for years or even decades before starting income payments.

Types of Annuities

Annuities come in several types, each with different risk levels, growth potential, and fee structures. Understanding the differences is essential to choosing the right one for your goals.

Fixed Annuities

A fixed annuity pays a guaranteed interest rate for a set period. Your principal is protected, and your account value will never decrease due to market conditions. Fixed annuities are the simplest and most conservative type. They are regulated by state insurance departments and are not securities. A common subtype is the multi-year guaranteed annuity (MYGA), which locks in a fixed rate for a specific term, similar to a CD. As of February 2026, the best MYGA rates exceed seven percent for ten-year terms.

Variable Annuities

A variable annuity allows you to invest your money in sub-accounts, which work like mutual funds. Your account value rises and falls based on the performance of the investments you select. Variable annuities offer higher growth potential than fixed annuities but also carry more risk. You can lose money if the investments perform poorly. Variable annuities are securities and are regulated by the SEC. They typically carry higher fees than other annuity types, averaging two to three percent per year, which can significantly reduce your returns over time.

Fixed Indexed Annuities

A fixed indexed annuity (FIA) is a hybrid that combines features of both fixed and variable annuities. Your interest earnings are tied to the performance of a market index, such as the S&P 500, but your principal is protected by a floor, typically zero percent. This means you participate in some of the market's upside without the risk of losing money when the market drops. However, your gains are limited by caps (often three to seven percent) and participation rates (often 50 to 100 percent of the index gain). Indexed annuities are regulated by state insurance departments and are not considered securities in most states.

Immediate Annuities

An immediate annuity, also called a single premium immediate annuity (SPIA), begins paying income within 30 days of your purchase. You make one lump-sum payment and start receiving regular checks right away. SPIAs are popular with retirees who want to convert a portion of their savings into guaranteed lifetime income. For example, a 65-year-old might pay $100,000 and receive approximately $570 per month for life. Immediate annuities are straightforward and have low fees because there is no accumulation phase.

Deferred Annuities

A deferred annuity delays income payments to a future date. During the accumulation phase, your money grows tax-deferred. You decide when to begin withdrawals or convert the annuity into an income stream. Deferred annuities can be fixed, variable, or indexed. They are best suited for people who are still years away from retirement and want their money to grow before they need income.

Pros of Annuities

Annuities offer several benefits that other financial products cannot match. Here are the main advantages.

• Guaranteed income for life. An annuity can provide payments that last as long as you live, no matter how long that is. This is the only financial product that can guarantee you will never outlive your income.
• Tax-deferred growth. Your money grows without being taxed each year. You only pay taxes when you withdraw funds. This allows your savings to compound faster than they would in a taxable account.
• No contribution limits. Unlike 401(k) plans ($23,500 limit in 2026) and IRAs ($7,000 limit in 2026), non-qualified annuities have no government-imposed contribution caps. You can invest as much as the insurance company will accept.
• Principal protection (fixed and indexed). Fixed and fixed indexed annuities protect your original investment from market losses. Your account value will not decrease due to stock market declines.
• Death benefit options. Many annuities include a death benefit that passes remaining value to your beneficiaries. Some offer enhanced death benefits for an additional fee.
• Probate avoidance. Annuity proceeds typically pass directly to named beneficiaries without going through probate, which can save time and legal fees.

Cons of Annuities

Annuities also have significant drawbacks that every buyer should understand before committing.

• Fees and expenses. Variable annuities are particularly expensive, with total annual fees averaging two to three percent per year. These fees include mortality and expense charges, administrative fees, fund management expenses, and optional rider fees. Even fixed and indexed annuities may have costs built into the rate or cap structure that are not immediately visible.
• Surrender charges. If you need to access your money early, you may face surrender charges that start around seven percent in the first year and decline over six to eight years. This makes annuities illiquid in the short term.
• Early withdrawal penalties. The IRS imposes a ten percent penalty on earnings withdrawn before age 59 and a half, in addition to ordinary income taxes. This is similar to the penalty on early withdrawals from 401(k) and IRA accounts.
• Complexity. Annuity contracts can be dozens of pages long with complicated terms, riders, exclusions, and fee schedules. The complexity can make it difficult to compare products and understand exactly what you are buying.
• Illiquidity. Once you annuitize a contract and begin receiving lifetime payments, you generally cannot access the remaining principal as a lump sum. Your money is locked into the payment stream. This lack of flexibility can be a problem if you face an unexpected large expense.
• Tax treatment of withdrawals. Annuity earnings are taxed as ordinary income when withdrawn, not at the lower capital gains tax rate. This can result in a higher tax bill compared to withdrawals from taxable investment accounts held for more than one year.

Who Benefits Most From Annuities?

Annuities are not the right choice for everyone, but they can be a strong fit for certain people and situations.

• Retirees without a pension. If you do not have a traditional pension, an annuity can create a pension-like income stream. This helps cover essential expenses alongside Social Security.
• People concerned about outliving their savings. If longevity runs in your family or you simply worry about running out of money, lifetime income from an annuity provides peace of mind.
• High earners who have maxed out other retirement accounts. Since annuities have no contribution limits, they offer additional tax-deferred savings for people who have already contributed the maximum to their 401(k) and IRA.
• Conservative savers seeking principal protection. Fixed and indexed annuities protect your principal from market losses, which appeals to risk-averse individuals who want growth without the possibility of losing money.

Annuities may not be the best fit for people who need easy access to their money, are in a low tax bracket, already have a pension, or have limited savings that should remain liquid for emergencies. A financial advisor can help you determine whether an annuity makes sense in your specific situation.

Tax Rules for Annuities

The tax treatment of annuities depends on whether the annuity is qualified or non-qualified.

Qualified annuities are purchased within a tax-advantaged retirement plan like a traditional IRA or 401(k). Contributions are typically made with pre-tax dollars, and the entire withdrawal amount is taxed as ordinary income. These are subject to required minimum distributions (RMDs) starting at age 73.

Non-qualified annuities are purchased with after-tax dollars outside of a retirement plan. Only the earnings portion of withdrawals is taxed as ordinary income. Your original contributions are returned to you tax-free since you already paid taxes on that money. Non-qualified annuities are not subject to RMDs.

The IRS applies a last-in, first-out (LIFO) rule to non-qualified annuity withdrawals. This means earnings come out first and are fully taxable. You do not receive the tax-free return of principal until you have withdrawn all of the earnings. Additionally, if you withdraw earnings before age 59 and a half, the IRS charges a ten percent early withdrawal penalty on top of ordinary income taxes. See IRS Publication 575 for detailed tax guidance on annuity income.

How to Choose an Annuity

Choosing the right annuity requires careful thought about your financial goals, timeline, risk tolerance, and income needs. Here are key questions to ask before buying.

• What is my primary goal? If you want guaranteed income, a fixed or immediate annuity may be best. If you want growth potential with some downside protection, an indexed annuity may work. If you want market-based growth and can tolerate risk, a variable annuity is an option.
• When do I need income? If you need income now, an immediate annuity starts payments right away. If retirement is years away, a deferred annuity gives your money time to grow.
• What are the total fees? Ask for a complete breakdown of all charges, including surrender fees, mortality and expense charges, administrative fees, fund expenses, and rider costs. Compare the total cost across multiple products.
• How strong is the insurance company? Your annuity is only as reliable as the company behind it. Check financial strength ratings from A.M. Best, Moody's, Standard and Poor's, and Fitch.
• What is the surrender period? Know how long your money will be locked up and what penalties apply if you need to access it early.

A qualified financial advisor can help you compare options and determine whether an annuity fits within your broader retirement plan. Take your time, read the contract carefully, and never feel pressured into a quick decision.

The Bottom Line

An annuity is an insurance contract designed to provide guaranteed income in retirement. Fixed annuities offer safety and predictability. Variable annuities offer growth potential with more risk and higher fees. Indexed annuities sit in between, offering some market participation with downside protection. Immediate annuities start paying right away, while deferred annuities let your money grow first.

The biggest advantages of annuities are guaranteed lifetime income, tax-deferred growth, and no contribution limits. The biggest drawbacks are fees, surrender charges, complexity, and limited access to your money. Annuities work best for retirees without pensions, people worried about outliving their savings, and high earners who have maxed out other retirement accounts.

Before purchasing any annuity, consult a qualified financial advisor who can evaluate your complete financial picture. Annuities are long-term commitments, and the right choice depends on your individual goals, risk tolerance, and retirement timeline.