Annuities explained: types, costs and how they pay

An annuity is a contract between you and an insurance company: you pay a premium, in one lump sum or over time, and the company promises payments back to you, now or later, for a set period or for the rest of your life. Annuities mainly do two jobs: turning savings into income you cannot outlive, and letting money grow tax deferred until you need it. They come with trade-offs, including limited access to your money in the early years and surrender charges, and every promise in the contract depends on the claims-paying ability of the insurance company. An annuity is not a bank deposit and is not FDIC insured. In New Jersey you have a 10-day free-look period to cancel a new annuity for a refund of premiums, and the state guaranty association covers up to $250,000 of cash surrender or withdrawal value if an insurer fails.

Immediate or deferred

The first question is when payments start. With an immediate annuity, also called an income annuity, you pay a lump sum and income begins right away, generally within a year. With a deferred annuity, the money stays in the contract first and income or withdrawals begin later. A single premium annuity takes one payment; a flexible premium annuity takes several.

One decision deserves extra care. When you annuitize, meaning convert the contract into a stream of regular income payments, that choice generally cannot be undone: the payment terms are set, and you no longer have access to the money outside the payment plan you chose. That permanence is what makes lifetime income possible, and it is why annuitizing should only involve money you will not need as a lump sum.

Source: IRS Publication 575, Pension and Annuity Income.

Fixed, fixed indexed and variable

A fixed annuity credits interest at a rate the insurance company declares for a set period, with a minimum rate stated in the contract. A fixed indexed annuity is a kind of fixed annuity where the interest credited is linked to an outside market index, subject to limits such as a cap or participation rate, with a floor that protects credited value from index losses. Both are insurance products regulated in New Jersey by the Department of Banking and Insurance.

A variable annuity is different. Its value rises and falls with subaccounts you choose, so you can lose money, and it is a security as well as an insurance contract. The SEC's investor education site explains that variable annuities come with a prospectus and carry charges such as a mortality and expense risk charge, for example 1.25% a year, along with surrender charges and fees for optional benefits. Selling one requires a securities licence. This guide focuses on fixed and fixed indexed annuities; ask any agent which types they are licensed to offer.

Source: SEC Investor.gov: Variable annuities.

Payout options

• Life only: payments for your lifetime, ending at death. Usually the highest payment for each dollar.
• Joint and survivor: payments continue for a spouse after the first death, usually at a lower amount per payment.
• Period certain: payments for a set number of years, to you or your beneficiary.
• Life with period certain or refund: lifetime payments, with a minimum paid to your beneficiaries if you die early.
• Income riders on deferred annuities: a lifetime withdrawal benefit added for an annual charge, without annuitizing the account.

Surrender charges: a worked example in dollars

Most deferred annuities charge a surrender charge if you take out more than a penalty-exempt amount during the surrender period. The New Jersey Department of Banking and Insurance describes it as a penalty that is typically a percentage of the account value, and it has cautioned retirees to be careful with surrender charges that run beyond 10 years from purchase or when they may need large sums during that time. Each contract states its own schedule, and many allow a set percentage of the value to come out each year without a charge.

Hypothetical New Jersey household, not a real client, and an illustration only, not a product or a quote. A 54-year-old places $100,000 of savings (not IRA money) in a deferred fixed annuity. To show the math, assume a seven-year surrender schedule of 7%, 6%, 5%, 4%, 3%, 2% and 1%, with 10% of the contract value available each year without a charge, and the charge applied only to the amount above that. Real contracts differ in length, percentages and how the charge is figured.

If the owner surrendered the whole contract while the value was still $100,000, the charge would apply to $90,000, everything above the $10,000 penalty-exempt amount. The table shows what that would cost in each year of the illustration. Some contracts also apply a market value adjustment that can raise or lower the amount received, which is not shown here.

Illustration, not a quote: a hypothetical example using figures from SEC Investor.gov: Variable annuities.

The same example with federal taxes

Taxes are a separate cost. For a non-qualified annuity (one bought with after-tax money, like this one), IRS Publication 575 says amounts withdrawn before the annuity starting date come first from earnings, which are taxable, and then from your cost, which is not, for contracts bought after August 14, 1982. It also says most distributions from non-qualified annuities before age 59 and a half face an additional 10% tax on the taxable part, with listed exceptions.

Continue the illustration. In contract year 4 the owner is 58, the value has grown to $112,000, and the owner withdraws $20,000. The penalty-exempt amount is 10% of $112,000, or $11,200, so $8,800 is subject to the 4% charge: a $352 surrender charge. Because withdrawals come out of earnings first, the first $12,000 is taxable and $8,000 is a return of premium. At 58, the 10% additional tax applies to the $12,000 taxable part, adding $1,200. Waiting past 59 and a half, and past the surrender period, would have avoided both.

Illustration, not a quote: a hypothetical example using figures from IRS Publication 575, Pension and Annuity Income.

Taxes in plain English

• Growth inside a non-qualified annuity is tax deferred until you take it out.
• Withdrawals of earnings are taxed as ordinary income, and for contracts bought after August 14, 1982 they come out earnings first.
• Earnings taken before 59 and a half generally face an additional 10% federal tax, with exceptions listed in IRS Publication 575.
• An annuity inside an IRA gets no extra tax deferral; it is bought for its income or protection features, and required minimum distributions still apply, generally starting at 73.
• New Jersey: the Division of Taxation says annuities are taxable income for New Jersey residents, reported with pensions, and people 62 or older or disabled may be able to use the state's retirement exclusions if total income is $150,000 or less.
• Talk with your tax professional before moving retirement money. Jackie does not give tax advice.

New Jersey protections when you buy

New Jersey gives annuity buyers a 10-day free-look period: you can return a new contract and receive a refund of all premiums paid, for any reason. The Department of Banking and Insurance also requires companies to do a suitability review before selling an annuity, to check that the product fits your finances and goals, and it urges buyers to read the Buyer's Guide and the disclosure statement and keep asking questions until they understand the contract.

If an insurance company fails, the New Jersey Life and Health Insurance Guaranty Association provides a safety net within limits. Under P.L. 2024, c. 34, signed July 10, 2024, the association can pay an annuity owner up to $250,000 for a net cash surrender or net cash withdrawal on an annuity from an insolvent member insurer, up from $100,000. That safety net is not a reason to choose any contract; the company's own financial strength comes first.

How an annuity fits into a retirement budget

The most useful way to think about an annuity is as one possible answer to a specific gap. Start by listing your essential monthly expenses: housing, food, utilities, insurance premiums including Medicare, and transportation. Then list the income that lasts as long as you do, which for most people means Social Security and, for some, a pension. If lifetime income already covers the essentials, an income annuity has less work to do. If there is a gap, an immediate annuity or an income rider can be one way to close it, alongside other choices such as delaying Social Security, working part time or lowering fixed costs.

Our retirement planning checklist walks through a worked monthly budget using exactly this test. Whatever the answer, keep an emergency reserve outside any annuity, and size any purchase so the money left accessible covers surprises such as a roof, a car or a hospital deductible.

When an annuity may fit, and when it may not

Source: NJ Department of Banking and Insurance: annuity consumer rights press release (April 5, 2017).

What Jackie checks for you

Annuities come up as part of Jackie's no-cost Income Strategy Session, and the session starts with your income, not with products. You leave with the numbers in writing so you can take your time, talk it over with family or your tax professional, and decide without pressure. Deciding an annuity is not for you is a perfectly good outcome.

• Your monthly essentials versus income that lasts for life, to see whether there is a gap an income annuity could fill.
• How much money must stay accessible for emergencies and planned expenses, so nothing you may need sits inside a surrender period.
• Your age relative to 59 and a half and to your RMD age, and whether the money is IRA or after-tax savings.
• The full surrender schedule, the penalty-exempt withdrawal amount, any market value adjustment and every rider charge, in writing.
• For indexed contracts: the cap, participation rate or spread, how long each is set for, and the contractual minimum.
• If you are replacing an existing annuity: the surrender charge on the old contract, the new surrender period you would start, and what benefits you would give up.
• The company's financial strength, and that beneficiaries are named correctly.

Questions to ask before you sign

• What is the contractual minimum interest rate?
• What charges come out of my premium or contract value, and when?
• What are the surrender charges if I end the contract early, and for how many years do they apply?
• Can I take a partial withdrawal without charges or losing credited interest?
• Does the contract waive withdrawal charges if I am confined to a nursing home or diagnosed with a terminal illness?
• What income payment options do I have, and when can they start?
• What are the terms of the death benefit?
• For indexed annuities: what is the participation rate, the cap and any spread or fee, how long are they set, and which crediting method is used?
• How many days do I have to return the contract, and where is that stated?

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The bottom line

An annuity can be a sensible way to turn part of your savings into income you cannot outlive, but only when the money can stay put through the surrender period and the contract is clear to you. Ask for the surrender schedule in dollars, check your age against 59 and a half, and use your 10-day free-look period. Jackie's no-cost Income Strategy Session starts with your income needs and only then looks at whether an annuity belongs in the plan. Call or text (856) 727-4221.