An annuity is a contract, not an account
An annuity is an agreement with an insurance company. You hand over money, either in one payment or over time, and the company agrees to pay you back later: as a lump sum, over a set number of years, or for the rest of your life.
That last option is the one annuities exist for. Most retirement products help you build a pot of money. An annuity is the product that turns a pot of money into a payment that does not stop while you are alive, which is a different problem and the reason people buy them.
Because it is a contract with one company rather than a deposit at a bank, an annuity is not FDIC insured. What stands behind the promise is the insurer’s own ability to pay its claims, which is why the carrier matters as much as the terms.
Fixed, indexed and variable are regulated differently
Nearly every annuity is a variation on three designs, and the difference that matters most is who carries the investment risk.
The regulator follows the risk. Variable annuities are securities: they are registered with the SEC, sold with a prospectus, and the people who sell them are supervised by FINRA as well as the state. Fixed annuities are insurance products regulated by the state insurance department. Indexed annuities sit in between, and the SEC regulates only those that are securities, so some are and some are not.
| Fixed | Indexed | Variable | |
|---|---|---|---|
| Who carries the investment risk | The insurer | Shared | You |
| How the value grows | At an interest rate the contract sets | Tied to an index, with a cap or participation rate the contract sets | With the subaccounts you choose |
| Can the account value fall with the market? | No | Not from index losses, though charges still apply | Yes |
| Registered with the SEC as a security | No | Only some | Yes |
| Sold with a prospectus | No | Only when it is a security | Yes |
Source: SEC Office of Investor Education and Advocacy, Annuities
Saving up, then drawing down
A deferred annuity has two stages. During the accumulation phase the money grows inside the contract and you are not taxed on that growth yet. During the payout phase the company starts paying you, and how much depends on the contract, your age and the option you pick.
An immediate annuity skips the first stage: you pay a lump sum and payments start within about a year. It is the simpler product and the one people buy at retirement rather than years ahead of it.
Converting the contract into a stream of payments is usually irreversible. That is the trade being made: you give up access to the balance and get a payment that does not run out.
The surrender period is the cost people miss
Take money out during the early years and the contract charges you for it. The charge is a percentage of the amount withdrawn, it usually starts high and falls each year, and the window it applies to runs for years rather than months: FINRA describes surrender periods of roughly six to ten years on indexed annuities and eight years or more on some variable contracts.
Florida limits this for older buyers. Under section 627.4554(9) of the Florida Statutes, an annuity issued to a consumer aged 65 or older may not carry a surrender or deferred sales charge of more than 10 percent of the amount withdrawn, and the charge must fall to nothing after the later of the end of the tenth policy year or ten years after each premium payment. The limit does not apply to accredited investors or to certain employer plan contracts.
This guide quotes no rates, caps or participation rates, because those are set per contract and per carrier and change often. The schedule in your own contract is the only one that governs your money.
Deferred now, ordinary income later
Growth inside an annuity is not taxed each year. Tax arrives when money comes out, and the gain is taxed as ordinary income rather than at capital gains rates, which is a meaningful difference for anyone comparing an annuity with a taxable investment account.
Taking money out before age 59 and a half generally adds a further 10 percent federal tax on top of the ordinary income tax. IRS Publication 575 sets this out for both qualified plans and nonqualified annuity contracts, and it applies only to the taxable part of the distribution, not to a return of what you paid in.
There are exceptions, including payments taken as a series of substantially equal periodic payments and distributions after disability. Which exception applies to you is a question for a tax adviser, not for a guide.
What to ask, and when an annuity is the wrong answer
An annuity is a long commitment and it suits a specific job: money you will not need to reach for, bought to produce income you cannot outlive. It fits poorly when the money is an emergency fund, when the time horizon is short, or when the surrender schedule would still be running at the age you expect to need the balance.
- How long is the surrender period, and what does the charge cost in each year of it?
- Which design is this, and if it is indexed or variable, what are the caps, participation rates or subaccount charges?
- What are the annual charges, including any mortality and expense risk charge and administrative fees?
- What is the carrier’s financial strength, given that the promise rests on its ability to pay claims?
- What exactly is guaranteed in writing in the contract, as opposed to illustrated?
- What happens to the money if I die during the accumulation phase?
Frequently asked questions
What is an annuity in plain terms?
It is a contract with an insurance company. You pay money in, and the company pays money back later, either over a set period or for as long as you live. Its distinctive job is producing income that does not stop while you are alive.
Are annuities FDIC insured?
No. An annuity is a contract with an insurance company rather than a bank deposit, so no federal deposit insurance applies. The payments rest on the insurer’s ability to pay its claims, which is why the financial strength of the carrier matters.
What happens if I take my money out early?
Two charges can apply. The contract may levy a surrender charge during its surrender period, and the IRS generally adds a 10 percent federal tax to the taxable part of a distribution taken before age 59 and a half, with some exceptions.
Are all annuities regulated by the SEC?
No. Variable annuities are securities registered with the SEC and sold with a prospectus. Fixed annuities are regulated by the state insurance department. Indexed annuities vary: the SEC regulates only the ones that are securities.
Does Florida limit annuity surrender charges for older buyers?
Yes. Section 627.4554(9) of the Florida Statutes says an annuity issued to a consumer aged 65 or older may not carry a surrender or deferred sales charge above 10 percent of the amount withdrawn, falling to nothing after the tenth policy year or ten years after each premium, whichever is later.
Sources
This guide explains officially published rules and figures. It is not an insurance quote and not an eligibility determination. Only HealthCare.gov, Medicare.gov, Social Security or the carrier can determine your eligibility and your actual price.
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