Explaining the Different Types of Annuities

Those nearing retirement may look for ways to supplement their income. If accounts like a 401(k) or IRA are already maxed out, an annuity may be an option. Annuities come in different forms, including fixed, variable, indexed, immediate and deferred. Here is a breakdown of the main types to help you see how each could fit into your financial plan. If you prefer hands-on help, a financial advisor can explain the options and guide you in choosing an annuity that aligns with your goals.

Annuity Basics

An annuity is a contract between an investor and an insurance company. The investor buys an annuity with a lump sum of money and the insurance company promises regular disbursements for a specific period of time in return. These payments begin when the investor, also called the annuitant, chooses to annuitize their investment. The annuitant chooses the amount paid and how frequently they receive the payments. They also decide if they want a lump sum payout or regular disbursements. However, it all depends on the type of annuity.

Annuities may also earn interest, but the amount depends on the type of annuity and market conditions. They also enjoy tax-free growth, which can be another attractive aspect for investors. Keep in mind though that you will pay income tax on all or part of the annuity disbursements. There’s also typically a 10% tax penalty on the interest earned if you withdraw money before age 59 1/2.

Many see these contracts as a great way to supplement their retirement income stream, some even view annuities as a guarantee against running out of money during retirement. That, of course, depends on the type of annuity you invest in and the duration of your annuitization payments.

Fixed Annuities

A fixed annuity offers a guaranteed interest rate for a set period and is one of the most common, straightforward annuity types.

A fixed annuity provides an investor with a guaranteed interest rate for a set number of years. Fixed annuities are one of the most common forms of annuities and are fairly straightforward.

Basically, the purchaser invests a sum of money with an insurance company. The company then agrees to pay a set amount of interest for a predetermined amount of time, plus principal protection, as a return on the investment.

If you invest in a fixed annuity, how you receive your earnings varies between a set number of years or for life. The latter makes this type of annuity popular with those in retirement. You can also opt to receive your funds via a lump sum payout. Keep in mind that this type of annuity is not linked to market performance.

Variable Annuities

With a variable annuity, a purchaser pays into an annuity, but does not receive a guaranteed interest rate for a set period of time. Instead, an investor would receive returns based on the performance of the investments within the annuity. These investments can range from stocks and bonds to money market instruments and adhere to different risk tolerance levels. This allows for potentially greater returns, but also less-than-stellar ones. While the overall risk is higher with this type of annuity, it still provides principal protection.

Indexed Annuities

An indexed annuity is an annuity contract that guarantees a minimum rate of return, with the potential for higher returns based on market performance. This type of annuity is commonly based on indexes such as the S&P 500, but can also follow other indexes as well, depending on investor preference. It’s often known as a fixed indexed annuity since it combines features of both a fixed annuity and a variable annuity.

Indexed annuities can earn larger returns for investors. However, overall income can be limited by rate caps, which limit the returns an annuity holder can claim over a certain timeframe. This type of annuity also has a minimum rate of return, often about 2%. Even though these indexed annuities contracts can be more volatile, the principal is still guaranteed – unless you make a withdrawal, of course.

Immediate Annuities

Immediate annuities may be ideal for those who have a large amount of money on hand. An investor buys an immediate annuity with a large lump sum payment and then receives regular payments over a set period of time or as long as they live. Payments begin immediately (hence the name) and the investor can earn a fixed or variable interest rate.

So why would you tie up a large amount of cash in an annuity? There are a few reasons. An annuity grows tax-deferred. It also provides a steady stream of income for a set period of time and takes away the worry and anxiety around managing a large sum of money.

Deferred Annuities

With deferred annuities, an investor receives payments in the future only after the initial amount used to buy the annuity has accrued interest. Basically, it’s the opposite of an immediate annuity.

Deferred annuities have an investment phase and an income phase. The first phase begins when an investor buys the annuity and ends when the last contribution is made. You can contribute one lump sum or pay into the annuity over time. You start the income phase once you’re done making your contributions. This is when you receive payment, either in one lump sum or through disbursements over time.

Fixed, variable and indexed annuities can also be deferred annuities.

Costs and Fees of Annuities

Annuities can be useful retirement tools, but they often come with costs that reduce overall returns. These costs vary widely depending on the type of annuity and the features you choose. Understanding the fees can help you compare contracts before you buy.

Most annuities charge mortality and expense (M&E) fees, administrative fees and, in the case of variable annuities, investment management fees. Together, these charges often total between 1% and 3% of the account value each year. Fixed and immediate annuities usually have lower costs, while variable and indexed annuities are more expensive because of the underlying investments and features.

Surrender charges are another important cost. These are penalties you pay if you withdraw money too soon, usually within the first five to 10 years. A typical schedule starts at 7% in the first year and declines each year until the fee disappears. Riders, such as guaranteed income or enhanced death benefits, can add another 0.5% to 1.5% annually to the contract cost.

Because these expenses reduce your long-term growth, it’s important to compare fees among insurers and understand how long you may be locked into the contract. Annuities are less liquid than other investments, so knowing the true cost is key before you commit.

Annuity Type	Common Annual Fees	Surrender Charges	Other Costs
Fixed	0% – 1% (built into rate spread)	5–7 years, starting ~7%	Minimal, no riders required
Variable	2% – 4% (M&E, admin, fund expenses)	7–10 years, starting ~7%	Riders: 0.5% – 1.5% each
Indexed	0% – 1.5% (spread or participation fees)	7–10 years, starting ~7%	Riders: 0.5% – 1.5% each
Immediate	None (costs factored into payout rate)	None (payments start right away)	Optional rider costs
Deferred	1% – 2% (depends on fixed, variable, or indexed structure)	5–10 years, starting ~7%	Riders: 0.5% – 1.5% each

Bottom Line

Closeup of two hands holding small growing plants from smallest to biggest to represent different types of annuities.

There are several important distinctions between fixed, variable, indexed, immediate and deferred annuities. There are also qualified and unqualified annuities, which are distinguished by their tax treatment. It’s important to do your homework before deciding which type of annuity to purchase. Overall, you may only want to invest in an annuity if you have maxed out your other retirement savings vehicles and won’t need access to the cash in the near future, as annuities are relatively illiquid. And remember, the success of your investment may depend on the financial health of the insurance company backing it.

Tips for Growing Your Money

A financial advisor may be able to help you find the right vehicle for your money to grow in. Finding the right financial advisor that fits your needs doesn’t have to be hard. 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.
An annuity may help you diversify your portfolio. Consider your risk tolerance and all of the various types of investments that can help your money grow. From stocks and bonds to mutual funds and exchange-traded funds (ETFs) there are many investments to consider outside of annuities.