One of the biggest worries in retirement is running out of money. Social Security covers only part of most people’s expenses, and a stock portfolio can rise and fall with the market. An annuity can fill that gap by turning a portion of your savings into a stream of income that can last for life. Before you sign anything, though, it pays to understand how to buy an annuity the right way, because these contracts can be complex and expensive to exit.
What Is an Annuity?
An annuity is a contract between you and an insurance company. You pay a lump sum or a series of payments, and in return the insurer promises to make payments to you, either right away or at a future date. The U.S. Securities and Exchange Commission offers a plain-language definition of annuities on Investor.gov that is worth reviewing before you shop.
Annuities have two main phases. During the accumulation phase, your money grows tax-deferred. During the payout (annuitization) phase, you receive income.
The Main Types of Annuities
Immediate Annuities
With a single premium immediate annuity (SPIA), you hand over a lump sum and start receiving income within a year. They are simple and are often used by retirees who want a guaranteed paycheck now.
Deferred Annuities
A deferred annuity grows over time and pays income later. It suits people still working or those who want to lock in future income.
Fixed Annuities
Fixed annuities pay a guaranteed interest rate for a set period. A multi-year guaranteed annuity (MYGA) works much like a certificate of deposit issued by an insurer.
Fixed Indexed Annuities
Indexed annuities credit interest based on a market index, such as the S&P 500, subject to caps or participation rates. Your principal is generally protected from market losses, but your upside is limited.
Variable Annuities
Variable annuities invest in subaccounts similar to mutual funds. They offer growth potential but also carry market risk and usually the highest fees, especially when optional riders are added.
Step-by-Step: How to Buy an Annuity
Step 1: Define Your Goal
Decide what problem you want the annuity to solve. Are you creating a lifetime income floor, protecting principal, or deferring taxes on savings? A clear goal narrows your choices quickly.
Step 2: Decide How Much to Invest
Most planners suggest annuitizing only part of your savings. Add up your essential monthly expenses, subtract Social Security and any pension, and consider using an annuity to cover the remaining gap. Keep enough in liquid accounts for emergencies and unexpected costs.
Step 3: Choose the Funding Source
You can buy an annuity with cash savings (a non-qualified annuity) or with retirement money such as an IRA or 401(k) (a qualified annuity). If you are moving funds from a former employer’s plan, read our guide on how to roll over a 401(k) to avoid taxes and penalties during the transfer.
Step 4: Check the Insurer’s Financial Strength
An annuity is only as strong as the company behind it. Look up ratings from agencies such as AM Best, S&P and Moody’s, and favor insurers rated A or higher. State guaranty associations provide some backup protection if an insurer fails, but coverage limits vary by state.
Step 5: Compare Quotes from Several Companies
Payout rates for the same deposit can differ meaningfully between insurers. Get quotes from at least three highly rated companies. An independent agent or fee-only advisor can help you compare products from multiple carriers rather than a single company’s lineup.
Step 6: Understand Every Fee
Common annuity costs include:
- Surrender charges: Penalties for withdrawing more than allowed during the first several years, often starting around 7% and declining annually.
- Mortality and expense charges: Ongoing fees on variable annuities.
- Rider fees: Extra annual charges for features like guaranteed lifetime withdrawal benefits or enhanced death benefits.
- Investment management fees: Charged on variable annuity subaccounts.
Ask for the total annual cost in writing and make sure you understand it before you commit.
Step 7: Choose Your Payout Option
Typical options include life only (highest payment, ends at death), joint and survivor (covers two people), period certain (guaranteed for a set number of years), and life with a refund feature. Each option trades a higher monthly check against protection for your heirs.
Step 8: Use the Free-Look Period
After purchase, most states give you a free-look window, often 10 to 30 days, to review the contract and cancel for a refund. Read the final contract carefully during this time.
Tax Rules to Know
- Growth inside an annuity is tax-deferred until withdrawn.
- Earnings withdrawn before age 59½ may face a 10% IRS penalty in addition to income tax.
- For non-qualified annuities, only the earnings portion of each payment is taxable; for qualified annuities, payments are usually fully taxable.
- A 1035 exchange lets you swap one annuity for another without triggering taxes, though new surrender charges may apply.
Pros and Cons of Annuities
Pros
- Guaranteed income that can last for life
- Protection from outliving your savings
- Tax-deferred growth
- Principal protection with fixed and indexed products
Cons
- Limited access to your money during the surrender period
- Fees that can be high, especially on variable products
- Fixed payments may lose purchasing power to inflation unless you buy a rider
- Complexity that makes comparison shopping harder
Red Flags When Buying an Annuity
Be cautious if a salesperson pushes you to move money quickly, promises unrealistic returns, or suggests replacing an existing annuity without explaining new surrender charges. Always ask how the seller is compensated, and never buy a product you cannot explain in your own words.
Final Thoughts
Learning how to buy an annuity comes down to matching the right product to a clear retirement goal. Define the income gap you need to fill, choose a financially strong insurer, compare quotes, understand every fee, and pick a payout option that fits your family. Used for part of your savings, an annuity can provide peace of mind that a predictable paycheck will keep arriving no matter what the markets do.
