What is an annuity and how does it work?

Think of it as a way to help create your own income stream in retirement.

How do annuities work?

An annuity is one way to help turn money you have saved into income you can use later. Many people think about annuities when they are planning for retirement and want steady income they can count on.

Annuities often have two main stages:

• Accumulation stage: this is when your money is in the annuity before payments begin. Depending on the annuity, the money may grow at a fixed rate or based on investment performance.
• Payout stage: this is when you start getting payments. The amount and timing depend on the type of annuity and payout choice you selected.

Types of annuities

Annuity types can be categorized in multiple ways. One way is when payments start:

• Immediate annuity: Payments begin soon after you make a lump sum purchase. This may be a fit if you're at or near retirement and want income right away.
• Deferred annuity: Payments start at a later date you choose. Your money has time to grow before you begin drawing income, which may work well if you're still saving for retirement.

Annuities can also be classified based on how the funds are invested or funded:

• Fixed annuity: The insurance company takes on the investment risk and provides a set interest rate for a certain period. This type may appeal to people who want more predictable income.
• Variable annuity: Your money is tied to market-based investments such as bonds, stocks, money markets or mutual funds. Due to the risk of these types of investments, your payments may go up or down depending on how they perform.
• Indexed annuity: This type blends features of fixed and variable annuities. It may offer a base interest rate plus additional growth tied to a market index, such as the S&P 500®. Indexed annuities can be complex, so consider reviewing fees, limits, surrender charges and tax rules with your financial advisor or agent before purchasing.

Annuities pros and cons

An annuity can be helpful, but it may not be the right fit for every person. Here is a simple look at some of the trade-offs.

Annuities may help provide income in retirement, but they can also include fees, tax rules and limits on early access to money, so understanding the contract may help you decide if it is the right fit for you.

How to decide if an annuity fits your plan

An annuity may be worth considering if:

• You're concerned about outliving your savings
• You'd like predictable income in retirement beyond Social Security
• You've already maxed out contributions to your 401(k) or IRA and want another tax-deferred option
• You'd like to protect your beneficiaries with certain payout options

Common annuity payment and withdrawal options

Your annuity contract may offer several ways to take money out. The options can affect your payment amount, your spouse, your beneficiaries and your taxes.

• Life annuitization. This option pays you for life. The payment amount is based on factors such as age, life expectancy and the contract terms.
• Joint-life annuitization. This option can keep payments going for a spouse after you die. Payments may be lower because they are based on two lives instead of one.
• Period certain. This option guarantees regular income payments for a fixed number of years such as 5, 10, 15 or 20 years. If the owner dies before the term ends, the remaining payments go to a named beneficiary. If they outlive the term, payments stop.
• Life with guaranteed term. This option pays you for life, but it also has a set guaranteed period. If you die before that period ends, your beneficiary may keep getting payments until the period is over.
• Life annuity with cash refund option. This option ensures beneficiaries receive any remaining premiums if the annuitant dies before receiving payments equal to the premiums paid. Beneficiaries are protected from financial loss due to the early death of the annuitant. The provision is typically included as a rider on a life annuity, also known as a "pure life annuity" or a "straight life annuity." A cash refund annuity will typically cost the annuity buyer more in premiums.

Customers also can typically receive funds from an annuity in one of two ways:

• Systematic withdrawals. With this option, you choose how much to take and how often, based on your contract value. This may offer flexibility, but you could run out of payments if the account value is used up.
• Lump sum. A lump sum means taking the money all at once. This may create a larger tax bill and surrender charges or tax penalties may apply depending on the contract and timing.

FAQs

What is a retirement annuity?

A retirement annuity is another term to describe annuities, and it is a financial product used to help provide income in retirement. It can help turn part of your savings into regular payments. Some retirement annuities may pay for life, while others may pay for a set number of years.

Is an annuity the same as life insurance?

No. Life insurance is usually meant to help your beneficiaries after you die. An annuity is usually meant to help provide income while you are living, often during retirement.

Can an annuity help me avoid running out of money?

Some annuity options can provide income for life. That may help reduce the risk of outliving part of your retirement income. The exact benefit depends on the type of annuity, the payout option and the issuing company.

Are annuities taxable?

They can be. In many cases, annuity earnings grow tax-deferred. This means you do not pay tax on those earnings until money is paid out. Tax rules can vary based on the type of annuity, how it was funded and how you take withdrawals. Talk with a tax advisor about your situation.

Can I take money out early?

You may be able to, but it can cost you. Some contracts have surrender charges. Taxes may also apply. Some early withdrawals before age 59½ may face an added 10% federal tax penalty unless an exception applies.

Are all annuities guaranteed?

No. Fixed annuities may offer guaranteed rates or payments, depending on the contract. Variable annuities can rise or fall with investment performance. Also, annuity guarantees depend on the financial strength and claims-paying ability of the issuing insurance company.

How to get started

If a retirement annuity sounds like something you'd like to explore, connecting with a local State Farm agent is a good place to start. An agent can walk you through the different annuity options, help you understand the costs and features involved and work with you to see how annuity might fit into your broader retirement plan.