An annuity is a contract between you and an insurance company. In other words, you make a lump-sum payment or in instalments and, in return, receive regular disbursements, beginning either immediately or at a later date.

Key Takeaways

Annuities are insurance contracts that promise to pay you regular income immediately or in the future.

A deferred annuity has an accumulation phase followed by a disbursement (annuitization) phase; an immediate annuity converts a lump sum into cash flows from day one.

You can buy an annuity with either a lump sum or a series of payments.

Annuities come in three main varieties—fixed, variable, and indexed—each with its level of risk and payout potential.

The income you receive from an annuity is typically taxed at regular income tax rates, not long-term capital gains rates, usually lower.

Understanding Annuities

The goal of an annuity is to provide a steady stream of income, typically during retirement. Funds accrue on a deferred tax basis and, like 401(k) contributions—can only be withdrawn without penalty after age 59½.1

Many aspects of an annuity can be tailored to the buyer's specific needs. In addition to choosing between a lump-sum payment or a series of payments to the insurer, you can choose when you want to annuitize your contributions—that is, start receiving payments. An annuity that begins paying out immediately is referred to as an immediate annuity, while one that begins at a predetermined date in the future is called a deferred annuity.

The duration of the disbursements can also vary. You can choose to receive payments for a specific period, such as 25 years, or the rest of your life. Of course, securing a lifetime of costs can lower the amount of each check, but it helps ensure that you don't outlive your assets, which is one of the main selling points of annuities.

Types of Annuities

Annuities come in three main varieties: fixed variable and indexed. Each type has its level of risk and payout potential. For any of these, it is often structured as a deferred annuity.