Annuity
An annuity is a financial contract, typically issued by an insurance company, that accepts a lump-sum premium or a series of payments and in return provides a stream of income payments over a specified period or for the lifetime of one or more individuals.
Annuities serve two broad functions in retirement planning: accumulation, during which money grows on a tax-deferred basis, and distribution, during which the insurer makes regular income payments to the annuitant. They are unique among financial products in that they can guarantee income the annuitant cannot outlive — a feature that addresses longevity risk in a way that stocks, bonds, and bank accounts cannot replicate.
The tax treatment of annuities under the Internal Revenue Code is distinct from other retirement vehicles. Contributions to a non-qualified annuity (purchased outside an IRA or employer plan) are made with after-tax dollars, so when distributions begin, only the earnings portion is subject to income tax; the return of principal is not. However, earnings withdrawn before the contract's annuity starting date are taxed on a last-in, first-out (LIFO) basis — meaning earnings come out first and are fully taxable — and are subject to a 10% additional tax if the owner is under age 59½.
Annuities held inside an IRA or qualified plan are called qualified annuities. All distributions from these contracts are taxable as ordinary income because the original contributions were made on a pre-tax basis. The required minimum distribution rules that apply to IRAs and employer plans also apply to qualified annuities.
Annuity contracts come in many forms. Fixed annuities credit a guaranteed interest rate. Variable annuities allocate premiums to sub-accounts similar to mutual funds, with returns fluctuating based on market performance. Fixed indexed annuities link credited interest to the performance of a market index such as the S&P 500, subject to participation rates and caps. Immediate annuities begin income payments within one period of the premium payment, while deferred annuities accumulate value before converting to an income stream at a future date.
Surrender charges are a critical feature that potential buyers must understand. Most deferred annuity contracts impose a surrender charge schedule — often lasting 6 to 10 years — that imposes a penalty if the owner withdraws more than a specified free-withdrawal amount before the surrender period ends. These charges compensate the insurer for the upfront commissions paid to the selling agent. The DOL's fiduciary rule framework requires that recommendations of annuities within IRAs meet a best-interest standard, though the regulatory landscape in this area has evolved considerably since 2016.