Annuities are long-term contracts between individuals and insurance companies that individuals typically enter into as part of retirement planning. Individuals make payments to the insurance company, which the insurance company will in turn invest. Insurance companies will then make regular disbursements to the individual, which are guaranteed for an agreed upon period of time. In essence, an individual pays for the guarantee of income during retirement years, for the insurance company to grow the payments, and to remove the risk that the individual outlives their retirement savings.
Although the balance grows tax-free, it is important to note that the periodic disbursements to the individual are subject to income tax. Unlike a traditional 401(k) account, the money contributed to an annuity does not reduce an individual’s taxable income. Consequently, experts often recommend buying annuities after contributing the maximum amount to pre-tax retirement accounts for the year.
Further, annuities are not all created equal: they can be fixed, variable, and indexed—each accompanied by a set of benefits and risks. Fixed annuities guarantee a fixed rate of interest on an individual’s money for a specific period of time. In contrast, a variable annuity allows individuals to invest in various securities such as mutual funds, with the disbursements dependent upon the success of the investments. Indexed annuities combine the benefits of fixed and variable annuities because its returns are based upon the performance of a stock market index like the S&P 500—not on an individual’s investment decisions.
Beyond the investment and return options discussed above, the annuity terms also vary. There exist fixed-period annuities, life annuities, and life with period certain annuities. Fixed-period annuities guarantee payments for a set length of time, such as 10, 15, or 20 years. In contrast, life annuities end at the death of the owner. Lastly, life with period certain annuities guarantee the owner payment for their life but they can also choose a fixed period of guaranteed payment. Thus, while some annuities will end payments upon the owner’s death, others will continue to disburse payments to a beneficiary. Under trust and estates law, certain annuities can be considered non-probate assets that are payable to designated beneficiaries at death and pass by operation of law.
[Last updated in June of 2022 by the Wex Definitions Team]