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Financial Planning

How Do Annuities Work?

Natalie Montanez

Why it matters

  • Depending on your goals and risk tolerance, annuities can be a smart addition to your retirement portfolio.
  • Annuities create the opportunity for tax-deferred growth and a steady income stream in retirement.1
  • You can also leave a gift for your loved one with an annuity.4

When planning for retirement, the goal is to make sure you’re saving enough to fund the lifestyle you want. If an annuity product isn’t part of your retirement plan, you may be surprised by some of their key features. Annuities offer the opportunity to receive stable, guaranteed income throughout your retirement, while enjoying tax-deferred growth1 and the ability to leave a legacy. They can also be a good way to address the risk of potentially outlasting your savings,2 lessen the income-reducing effects of inflation, and limit downside risk. In 2021, retirement annuity assets totaled $2.5 trillion.3

What are retirement annuities and how do they work?

An annuity is a long-term insurance contract. They typically involve just two parties, but they can include as many as four — the issuer (usually an insurance company), the owner of the annuity, the annuitant (often the same person as the owner), and a beneficiary.4

Here’s how an annuity generally works: You agree to pay an insurance company a lump sum or a series of premium payments. Based on the claims-paying ability of the insurance company, when you retire, the insurance company pays you out at regular intervals, usually until your passing. You can use it as an income stream for a set number of years or even the rest of your life. There are different types of annuities and several ways to classify them, including immediate or deferred, and fixed or variable. We’ll touch on their differences a little later on.

An annuity’s lifecycle includes two main phases: accumulation and payout.2 The accumulation phase is the period when an annuity is funded — either in one lump sum or via a series of smaller payments — and before payouts begin. During the accumulation phase, money invested in the annuity grows on a tax-deferred basis. The payout phase begins once money starts to be paid out from the annuity.

Variable annuities are regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulation Authority (FINRA).2 Agents selling annuities must have a state-issued license, as well as a securities license if they sell variable annuities.2

Tax-deferred accumulation

Annuities can be an important part of your retirement planning. Similar to individual retirement accounts (IRAs) and 401(k)s, money that’s invested into an annuity will grow tax-free, and it won’t be subject to capital gains taxes.5 Unlike IRAs and 401(k)s, there’s no limit to the amount you can contribute to an annuity, making it a potentially good choice if you’ve already maxed out what you can contribute to your retirement accounts for the year. However, your payouts (distributions) are taxed just like regular income, and surrender charges may apply.


Annuities are generally designed to provide a steady, reliable income stream during retirement. They can help create confidence by knowing that you’ll have the money you need throughout your retirement.2


As the owner of the annuity, you’ll be able to designate a beneficiary to inherit your investment.4 This allows you to leave a legacy and ensure your loved ones are provided for in the future.

Investment protection

Some annuities are designed with floors and caps on their interest rates.6,7 Floors protect annuity owners from downturns in current rates and guarantee a set interest rate will be credited to the investment funds of a fixed or indexed annuity.6 A cap is an interest rate that limits the growth of an indexed annuity.7 Caps ensure the annuity provider can meet their obligations to the annuitant and still make a profit on the annuity.

Immediate vs. deferred annuities

Immediate annuities begin paying out as soon as you deposit a lump sum into them. Deferred annuities begin paying out when you reach the age of your choice. The advantage with deferred annuities is that your investment has time to grow tax-free while you wait for the payouts to begin.2

Customize your annuity with riders

Annuity contracts can be designed with a number of riders, letting you design an annuity that meets your needs.8 For example, riders can let you designate a specific beneficiary for your annuity or have your payout adjust with inflation. The guaranteed lifetime withdrawal benefit is a common rider. It lets you withdraw a certain percentage of the principal each year until you’ve withdrawn the full amount — a helpful hedge against longevity risk.8 When designing your annuity, think about where it fits into your retirement portfolio.

The different types of annuities

Most annuity contracts fall into one of three categories: variable, indexed, and fixed.1 The differences in these annuities determine how your annuity will grow.

Variable annuities

The value of a variable annuity changes based on the performance of an underlying portfolio of sub accounts that you select. Variable annuities give the possibility of increased returns during the accumulation phase. However, with greater returns comes the possibility of greater losses, making them riskier than fixed annuities.9 Variable annuities are subject to investment risks, including possible loss of principal.

Indexed annuities

While a variable annuity bases its interest rate on a portfolio, an indexed annuity pays interest based on how a certain market index, like the S&P 500, performs. You’ll hear indexed annuities sometimes called equity-indexed or fixed-indexed annuities.10

Fixed annuities

Fixed annuities pay out based on a specific, guaranteed interest rate. Due to their fixed nature, they offer lower risk than variable annuities, but they lack the potential for high growth that a variable annuity brings.6, 11

Qualified vs non-qualified annuities for retirement

You can purchase an annuity with either pre-tax or after-tax dollars. A non-qualified annuity is purchased with after-tax dollars, while a qualified annuity is purchased with pre-tax dollars. Only the earnings of a non-qualified annuity are taxed at the time of withdrawal, not the contributions, since those were made with after-tax dollars.2 Non-qualified annuities can be a good option if you’ve already maxed out your employer-sponsored retirement plan contributions or if you don’t have an employer-sponsored plan and want to let your money grow in a tax-deferred account. A qualified annuity effectively reduces your income, and taxes owed, for the year in which you make the contribution.

An annuity can be a smart addition to your retirement portfolio, especially as you get closer to retirement or if you’re more concerned about the risk of outlasting your savings.12 Since annuities can be structured in a variety of ways — variable, indexed, or fixed; qualified or non-qualified — and can be personalized with riders, finding one that meets your specific needs and goals shouldn’t be difficult. As always, consult a financial professional for help designing the annuity product that’s best for you.

Things to consider

  • If having a guaranteed income stream throughout your retirement is appealing, give annuities a closer look.
  • Select an annuity product based on your risk tolerance and financial goals.
  • Customize your annuity with riders to help achieve the best retirement lifestyle for you.  


Transamerica Resources, Inc. is an Aegon company and is affiliated with various companies which include, but are not limited to, insurance companies and broker dealers. Transamerica Resources, Inc. does not offer insurance products or securities. The information provided is for educational purposes only and should not be construed as insurance, securities, ERISA, tax, investment, legal, medical or financial advice or guidance. Please consult your personal independent professionals for answers to your specific questions.

1Annuities,” Investor.gov, accessed November 2022
2Guide to Annuities: What They Are, Types, and How They Work,” Investopedia, October 2022
3Total Assets of Retirement Annuities in the United States from 2000 to 2021,” Statista.com, accessed November 2022
4Annuity Contract,” Investopedia, November 2020
5What Is a Deferred Annuity?” Forbes.com, April 2022
6Interest Rate Floors,” Annuity.org, September 2022
7Rate Caps,” Annuity.org, September 2022
8Annuity Riders & Contract Provisions,” Annuity.org, September 2022
9Variable Annuity: Definition and How It Works, vs Fixed Annuity,” Investopedia.com, April 2021
10Indexed Annuity,” Investopedia.com, February 2021
11Fixed Annuity,” Investopedia.com, April 2021
12Is An Annuity a Good Investment?” Annuity.org, October 2022