Definition: An annuity is a retirement plan in which an individual or business purchases an insurance contract that provides income for life. The money in the annuity comes from investments made by the company that sold the contract and earlier investments made by the buyer.

Annuities are designed to provide income until the money runs out. It could be periodic payments or a large one-time payment. Payments can be scheduled and designed to correspond to income in your retirement accounts. Payments can be automatic or optional, depending on how much you contribute to the account over time. Income generated by an annuity can be taxed at regular brackets rather than gradually reducing your withdrawals during retirement. Annuities can help retirees buy homes mostly with cash today instead of waiting until retirement to use a traditional annuity.

Selecting an immediate annuity or a deferred annuity is a crucial decision you should not take lightly. Even though they look similar, significant differences should be taken into account when making this investment decision. An immediate annuity is the best option if you want your money to begin earning interest immediately on the date you purchase it, usually after death. A deferred annuity, on the other hand, may offer the best potential for income in retirement but only if purchased at a time when you are confident that your income will top out at exactly what it would have been if you had remained working throughout your entire working life — meaning that it could never be higher than what it would have been if you had stopped working altogether. Knowing what you’re getting yourself into and its costing to your retirement should make you think about making this decision. 

Types of Annuities

1. Fixed annuities 

Fixed annuities can be a perfect choice if you have guaranteed income in retirement from work or are assured of getting a set amount of money from a set source, say a pension or a Social Security check. Fixed annuities come with low fees and are generally guaranteed to pay out the amount you promised when you opened the account. The risk with fixed annuities is that they get bought by investors who need a quick return and don’t care how they get it, so they’re willing to take on riskier investments. 

2. Variable annuity

A variable annuity is one in which income and expense recognition change over time. Income is earned from a specific source, usually a traditional pension. Expense recognition also changes over time; for example, if you start receiving pension income from work, your spending requirements will likely be less than if you weren’t receiving any income at all. Other sources of income may be obtained through a life insurance policy or private investments.

3. Indexed annuities  

Indexed annuities are a type of life insurance that provides you with a fixed income for the rest of your life, as well as a specified payout based on a risk-based investment strategy. This can help you grow your estate or reduce your tax bill, depending on how well the market goes. Indexed annuities are also known as cash accumulators, annuities with a cash value tied to certain underlying assets. Because these types of insurance offer a guaranteed minimum income level, they have lower administrative costs than other types of life insurance.

The last thing you want to do is purchase an annuity that could significantly affect your future tax liabilities. There are numerous tax consequences when you take an amount of money out of your savings. Even if the money grows intact over time, it could be harder to take advantage of favorable tax treatment because of changing rules for inherited annuities. 

There are two ways that an annuity may be advantageous. If the annuity itself is an investment and you make passive income, you may want to look at the tax treatment. Passive income is income earned from a business not subject to federal income tax. You can take advantage of this money by increasing your net worth, becoming more wealthy, or giving to charity. If the annuity is simply a loan, it should be treated like any other loan and taxed at the regular income tax rates.