How annuities work is simple at the core: you give an insurance company money, and it promises you guaranteed growth, tax deferral or income in return. Everything else in the contract is a variation on that deal.
An annuity is a long-term contract, not a savings account. This lesson covers the three trade-offs inside every contract, the difference between immediate and deferred annuities, and the four main types you will see in a proposal.
What are the three trade-offs in how annuities work?
Every annuity balances the same three things. Once you can spot them, any proposal gets easier to read.
- How your money grows. It might earn a fixed rate, a return linked to a market index, or the returns of investments you pick.
- When you can get to it. Most contracts limit withdrawals for a set number of years. Taking out more than allowed costs you a fee.
- What is guaranteed. Some contracts guarantee your principal, a rate or an income for life. Others guarantee very little.
Tax deferral is part of the appeal too. In a deferred annuity, you pay no tax on growth until you take money out.
More of one usually means less of another. A higher rate often comes with a longer lock-up, and more market upside usually means less protection.
Every guarantee in an annuity is a promise from the insurance company, backed by its ability to pay claims. Annuities are not bank deposits, and they are not FDIC insured. Lesson 3 covers exactly what stands behind that promise.
What is the difference between immediate and deferred annuities?
The biggest split is timing. An immediate annuity starts paying you soon after you buy it, while a deferred annuity grows first and pays later.
| Feature | Immediate annuity | Deferred annuity |
|---|---|---|
| When income starts | Usually within a year of purchase | Years or even decades later, if ever |
| How you pay in | One lump sum | A lump sum or several payments |
| Main purpose | Turn savings into a paycheck | Grow money tax-deferred, then decide how to use it |
| Typical buyer | Retired and ready for income now | Still working or in early retirement |
Most buyers today choose a deferred annuity because they want their money to grow before they touch it. That is why this course focuses on deferred contracts. Our guide to deferred vs immediate annuities goes further on the choice.
Do most people actually turn an annuity into income?
Usually not. LIMRA research on deferred annuity buyers finds the vast majority of owners never annuitize. That means they never convert the contract into a stream of lifetime payments.
- What most owners use it for. Tax-deferred growth, a guaranteed rate or protection of their principal.
- How they get money out. They take withdrawals along the way or turn on an income rider instead.
- Why it matters to you. If a contract charges extra for income features you may never use, ask whether a simpler product fits better.
For some buyers, guaranteed lifetime income is exactly the right feature. Just know what you are paying for before you pay for it.
What are the four main types of annuities?
Almost every deferred annuity sold today falls into one of four types. They run from the most predictable to the most market-driven.
| Type | How it grows | Downside protection | Main catch | Risk |
|---|---|---|---|---|
| Fixed or MYGA | A guaranteed rate for a set term | Principal guaranteed by the insurer | No upside above the locked rate | Lowest |
| Fixed index (FIA) | Interest linked to a market index | A 0% floor, so index drops do not reduce your value | Caps and participation rates limit gains | Low |
| Registered index-linked (RILA) | Index-linked, with higher caps than most FIAs | A buffer or floor absorbs part of a loss | You can lose money in a bad year | Moderate |
| Variable | Invested in subaccounts you choose | None from market losses on its own | Layered fees and full downside risk | Highest |
- Fixed and MYGA. Think of a MYGA as the annuity version of a CD, with tax deferral added.
- FIA. A fixed index annuity trades some upside for a floor that protects you from index losses.
- RILA and variable. Both put some or all market risk on you in exchange for more growth potential.
Lessons 4 to 7 cover each type in detail, with the questions to ask for each one.
When a proposal says your principal is protected, it means the insurance company guarantees it by contract. That promise is only as strong as the insurer behind it. No bank or federal agency stands behind it.
- How does this contract grow: a fixed rate, an index or investments?
- How many years is my money tied up, and what does it cost to leave early?
- Exactly what is guaranteed, and which insurance company makes that promise?
- Is this an immediate or a deferred annuity, and why is that the right fit for me?
- Am I paying extra for income features I may never use?
Check your understanding
Answer five quick questions to see what stuck from this lesson.
Lesson 1 quiz: How annuities work
5 questions. No sign-up, nothing saved to our servers.
Common questions
Is an annuity insurance or an investment?
Every annuity is an insurance contract. Variable annuities and RILAs are also registered securities, because your money is exposed to market losses.
Can you lose money in an annuity?
With a fixed annuity or an FIA, the insurer guarantees your principal against market drops. You can still lose money by paying a surrender charge if you leave early. With a RILA or variable annuity, your account value can fall with the market.
How long do you have to keep an annuity?
There is no legal minimum, but most deferred annuities charge a fee if you take out too much during the first several years. Surrender periods commonly run about 6 to 10 years.
Before you compare any rates, make sure you can name the three trade-offs in the contract in front of you. Next comes surrender charges and free withdrawals, the part of how annuities work that costs buyers the most when they get it wrong.