How to Use Annuities for Income in Retirement

Your retirement plan can keep you up at night, especially if you are nervous about outliving your nest egg. Many Americans get peace of mind by adding annuities to their retirement plans. This financial product is an insurance contract that can pay you retirement income for a certain amount of years, or for a lifetime. Here’s what you need to know.

A financial advisor can help you find additional sources of income to stretch out your retirement nest egg.

Types of Annuities

While annuities can pay you retirement income, their terms differ by contract. Generally, there are two types of annuities:

Immediate annuities: These are basic contracts that convert lump-sum contributions into streams of income. They can last for a specific number of years or for a lifetime.
Deferred annuities: By contrast, deferred annuities are structured to let policyholders build cash value through multiple contributions over a longer period of time.

Annuities are also categorized by the type of rates that the contract offers:

Fixed annuities: Fixed annuities guarantee a specific payout based on periodic payments.
Variable annuities: Meanwhile, variable annuities offer payouts based on how fund investments perform, meaning payouts could be either higher or lower.

How Do Annuities Pay Income?

You can buy an annuity through periodic contributions or by making one lump-sum deposit. In exchange for this money, the insurance company will offer you a stream of income that depends on the terms of your contract.

A fixed annuity, for example, can pay you a specific rate that is based on how much money you invest. Typically, the more time you have to put money in, the more you will be able to earn through compound interest.

A variable annuity, on the other hand, relies on performance. So this contract can actually pay you more than a fixed annuity when an investment offers high returns. You should note, however, that you can also lose money with market downturns.

One key note: Annuities allow your contributions to be tax-deferred. This means that you will need to pay taxes on that income when you make a withdrawal or get an annuity payment.

How Do Annuities Pay Income?

A variable annuity, on the other hand, relies on performance. So this contract can actually pay you more than a fixed annuity when an investment offers high returns. On the flipside, however, you can also lose money if there are market downturns.

One key note: Annuities allow your contributions to be tax-deferred. This means that you will need to pay taxes on that income when you make a withdrawal or get an annuity payment.

Costs and Fees of Annuities

Annuities often come with layers of fees that can reduce your overall return. Common charges include mortality and expense risk fees, administrative fees and investment management fees for variable annuities.

Surrender charges are another cost to consider. If you withdraw money within the first five to 10 years of owning the contract, you may pay penalties starting around 7% of the withdrawal amount, which typically decline each year until they phase out.

Many insurers also sell optional riders, such as guaranteed lifetime withdrawal benefits or enhanced death benefits. These can add another 0.25% to 1.50% annually. While riders may increase security, they also raise the cost of holding the annuity.

Because of these fees, an annuity may grow more slowly than other retirement investments, especially in the early years. Before buying, compare total costs against other retirement income products to see if the contract provides enough value for your situation.

Annuity Type	Common Annual Fees	Surrender Charges	Optional Rider Costs
Fixed	0% – 1.50% (built into credited rate)	5–7 years, starting ~7%	Minimal; usually not required
Variable	2% – 4% (M&E, admin, fund expenses)	7–10 years, starting ~7%	0.25% – 1.50% each
Indexed	1% – 3% (participation/spread costs)	7–10 years, starting ~7%	0.25% – 1.50% each
Immediate	None (factored into payout)	None	Optional riders available, cost varies

Pros and Cons of Using Annuities in Retirement

Let’s take a look at some of the reasons why you may want to buy an annuity:

You’ll have peace of mind. Annuities can offer you steady, guaranteed income. Many retirees may find this helpful in maintaining a reliable stream of income in their retirement.
You can pass money to a beneficiary. Many contracts include death benefits, which get paid to the person that you appoint as a beneficiary. This feature could require you to pay an additional cost, though, so do the math before buying the contract.
Your contributions willgrow tax-deferred. Annuities grow tax-deferred, meaning you won’t pay any taxes until you withdraw your funds. With compounding, this can help your funds grow.
You may have a guaranteed rate of return. If you opt for a fixed annuity, you will have a guaranteed rate of return. This provides predictable payments you can depend on.

But before you put your money into an annuity, also make sure to consider these four common drawbacks:

Annuities can be expensive. Depending on your contract, you’ll have to pay a variety of annuity fees. These can include commissions, expense ratios for investments and surrender charges. Make sure you compare these fees against other retirement income options to see which is a better fit for your retirement plan.
Insurance companies are not FDIC-insured. Unlike banks or credit unions, insurance companies are not covered by FDIC insurance. This means your annuity payments will rely on the company’s financial strength and its ability to pay those benefits.
Your money is locked by the terms of the contract. Annuities typically limit withdrawals to a percentage of the contract’s value. As a result, it could be difficult for you to gain access to your funds quickly without having to pay a surrender charge or lose on compound interest.
Your rate may not keep pace with inflation. Whether your contract is fixed, or you have a variable annuity that can capitalize on market upswings, your income payments could still fall short when your cost of living goes up.

Bottom Line

Couple reviews their Roth IRA's performance.

Buying an annuity can provide income for life and reduce the risk of outliving your retirement savings. However, annuities vary widely in structure, so it is important to review the contract carefully. Key considerations include the payout rate, ongoing fees, surrender charges and any riders or special features that may affect cost or flexibility. Evaluating how these terms align with your retirement goals, liquidity needs and other income sources will help determine whether an annuity is an appropriate addition to your plan.

Retirement Savings for Beginners

A financial advisor can help you create a financial plan for your retirement goals. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
SmartAsset’s free retirement calculator can help you figure out how much you will have for retirement based on your expected retirement age, annual income and retirement expenses.