A Guide to Buying an Annuity

Quick answer

• Annuities are insurance contracts that can provide a guaranteed stream of income, often for retirement.
• They are complex financial products, so understanding your needs and the annuity type is crucial.
• Consider your income needs, risk tolerance, and how long you might need the income.
• Compare quotes from multiple reputable insurance companies.
• Understand all fees, surrender charges, and payout options before purchasing.
• Consult with a qualified financial advisor to ensure an annuity fits your overall financial plan.

Who this is for

• Individuals seeking a predictable income stream, especially during retirement.
• Those who want to protect a portion of their savings from market volatility.
• People looking for ways to supplement other retirement income sources like Social Security or pensions.

What to check first (before you act)

Goal and timeline

Before exploring annuities, define what you want this purchase to achieve. Are you looking to supplement your retirement income for a set number of years, or do you want income for life? Your timeline is critical, as annuities can be structured for immediate payouts or deferred income.

Current cash flow

Understand your current income and expenses. How much disposable income do you have that could be allocated to an annuity? This will help determine how much you can afford to invest and what level of income you can realistically expect.

Emergency fund or safety buffer

Ensure you have a robust emergency fund in place. Annuities are generally long-term commitments, and you don’t want to be forced to withdraw funds prematurely, potentially incurring penalties or losing benefits. A sufficient emergency fund provides a safety net for unexpected expenses.

Debt and interest rates

Evaluate your outstanding debts. High-interest debt, like credit card balances, should typically be prioritized over purchasing an annuity. The interest you pay on debt often exceeds the potential returns or income guaranteed by an annuity.

Credit impact

While buying an annuity doesn’t directly impact your credit score like taking out a loan, the financial health of the issuing insurance company is paramount. A strong financial rating from independent agencies is a good indicator of the company’s ability to meet its future obligations.

Step-by-step (how to buy an annuity)

1. Assess your retirement income needs.

• What to do: Estimate your expected living expenses in retirement and identify any income gaps that Social Security or pensions won’t cover.
• What “good” looks like: A clear understanding of how much additional, reliable income you need each month or year.
• Common mistake: Underestimating retirement expenses or overestimating other income sources. Avoid this by creating a detailed retirement budget.

2. Determine your risk tolerance and investment horizon.

• What to do: Consider how comfortable you are with investment fluctuations and how long you anticipate needing income.
• What “good” looks like: A clear picture of whether you need guaranteed principal protection or can tolerate some market risk for potentially higher growth.
• Common mistake: Choosing an annuity that doesn’t align with your risk profile, leading to dissatisfaction or unexpected losses. Match the annuity’s features to your comfort level.

3. Understand the different annuity types.

• What to do: Research immediate annuities (for current income), deferred annuities (for future income), fixed annuities (guaranteed interest rate), variable annuities (investment-based, with potential for higher growth and risk), and indexed annuities (linked to a market index).
• What “good” looks like: Familiarity with the basic mechanics and risk/reward profiles of each major annuity category.
• Common mistake: Not understanding the nuances between types, leading to purchasing a product that doesn’t meet your specific needs. Focus on the core differences.

4. Consult with a qualified, fee-only financial advisor.

• What to do: Seek advice from a professional who acts as a fiduciary and is compensated directly by you, not by commissions from selling products.
• What “good” looks like: An advisor who explains options objectively and helps you integrate annuities into your overall financial plan.
• Common mistake: Working with a commission-based salesperson who may prioritize selling a high-commission product over what’s best for you. Prioritize independent advice.

5. Shop around and get multiple quotes.

• What to do: Contact several reputable insurance companies to compare annuity contracts and payout options for the type of annuity you’re considering.
• What “good” looks like: A range of offers from different insurers, allowing you to compare features, guarantees, and potential income amounts.
• Common mistake: Accepting the first offer without comparison, potentially missing out on better terms or rates. Always compare.

6. Scrutinize the contract details.

• What to do: Carefully read the annuity contract, paying close attention to fees, surrender charges (penalties for early withdrawal), death benefits, riders (optional features), and payout options.
• What “good” looks like: A complete understanding of all terms, conditions, and potential costs associated with the annuity.
• Common mistake: Overlooking hidden fees or restrictive surrender periods. Take your time and ask for clarification on anything unclear.

7. Verify the insurance company’s financial strength.

• What to do: Check the financial strength ratings of the insurance company from independent agencies like A.M. Best, Moody’s, S&P, and Fitch.
• What “good” looks like: An insurer with high financial strength ratings, indicating a strong ability to pay future claims.
• Common mistake: Purchasing from a financially unstable company. The guarantee of an annuity is only as good as the insurer backing it.

8. Consider the payout phase options.

• What to do: Decide how you want to receive your income – for a fixed period, for life, or for the joint lives of you and a spouse.
• What “good” looks like: A payout option that aligns with your longevity expectations and financial needs.
• Common mistake: Not choosing a payout option that adequately covers your expected lifespan. Plan for the possibility of living longer than average.

9. Complete the application and funding.

• What to do: Fill out the annuity application accurately and transfer the funds to the insurance company.
• What “good” looks like: A smooth transaction with all paperwork completed correctly.
• Common mistake: Providing inaccurate information on the application, which could lead to policy issues later. Double-check all details.

10. Review your annuity annually.

• What to do: Once purchased, periodically review your annuity statements and ensure it continues to meet your financial goals.
• What “good” looks like: Confirmation that the annuity is performing as expected and remains a suitable part of your financial strategy.
• Common mistake: Forgetting about the annuity after purchase, potentially missing opportunities to adjust or understand its performance. Stay informed.

Common mistakes (and what happens if you ignore them)

Mistake	What it causes	Fix
Not understanding annuity types	Buying the wrong product for your needs (e.g., high risk when you need security).	Thoroughly research and consult with an advisor to match the annuity type to your goals.
Ignoring fees and charges	Significantly reduced income stream or unexpected costs that erode principal.	Always read the fine print and ask for a breakdown of all fees, including surrender charges and riders.
Not verifying the insurer’s rating	The insurance company may struggle to pay benefits if it faces financial difficulties.	Only purchase from highly-rated, financially stable insurance companies.
Overlooking surrender charges	Heavy financial penalties if you need to access your money before the surrender period ends.	Understand the surrender period and its associated charges before committing your funds.
Choosing the wrong payout option	Income may stop too soon or not be sufficient for your lifetime needs.	Carefully consider your life expectancy and financial needs when selecting a payout option.
Treating an annuity like a savings account	High surrender charges and potential loss of benefits for early withdrawals.	Recognize annuities as long-term contracts, not liquid savings.
Not integrating with overall plan	Annuity may not align with other investments or retirement goals, creating gaps.	Work with an advisor to ensure the annuity complements your broader financial strategy.
Assuming “guaranteed” means risk-free	Variable annuities have market risk, and fixed annuities may not keep pace with inflation.	Understand the specific guarantees and limitations of your chosen annuity type.
Relying solely on sales pitches	Misleading information or emphasis on benefits without full disclosure of drawbacks.	Seek objective, unbiased advice and do your own due diligence.
Not understanding tax implications	Unexpected tax bills on growth or withdrawals.	Consult a tax professional to understand how annuity income will be taxed.

Decision rules (simple if/then)

• If your primary goal is guaranteed lifetime income and you are nearing or in retirement, then consider an immediate annuity because it converts a lump sum into regular payments.
• If you want to defer income to a future date and allow your principal to grow tax-deferred, then consider a deferred annuity because it offers flexibility for future income planning.
• If you have a high-risk tolerance and seek potentially higher returns, then a variable annuity might be an option, but understand its associated market risk and higher fees.
• If you want principal protection with a guaranteed minimum interest rate, then a fixed annuity is a suitable choice because it offers predictability.
• If you want to participate in market upside while having downside protection, then an indexed annuity might be considered, but be aware of caps and participation rates.
• If you need access to your funds within a few years, then an annuity is likely not the right choice because of high surrender charges.
• If you have significant high-interest debt, then prioritize paying off that debt before considering an annuity because the interest saved often outweighs annuity returns.
• If you are not comfortable with complex financial products, then stick to simpler investment vehicles or annuities with very straightforward terms because annuities can be intricate.
• If you are seeking a death benefit for beneficiaries, then look for annuities that offer specific death benefit riders, but understand this may increase costs.
• If you are concerned about outliving your savings, then an annuity that offers a lifetime payout option is a strong consideration because it provides longevity protection.
• If you are uncomfortable relying on insurance company ratings, then consider annuities from the most financially secure companies because their ability to pay is paramount.
• If you are unsure how an annuity fits into your overall retirement picture, then seek professional advice because it’s a significant financial decision.

FAQ

What is the main purpose of an annuity?

The primary purpose of an annuity is to provide a guaranteed stream of income, often for life, which can be a valuable tool for retirement planning to supplement other income sources.

Are annuities safe?

Annuities are generally considered safe because they are backed by the financial strength of the issuing insurance company. However, the safety depends on the insurer’s solvency, and variable annuities carry investment risk.

What are the downsides of buying an annuity?

Common downsides include high fees, surrender charges for early withdrawals, potential loss of purchasing power due to inflation (especially with fixed annuities), and complexity.

Can I get my money back if I change my mind?

You can usually withdraw funds, but most annuities have surrender charges that can be substantial if you take money out during the early years of the contract.

How are annuities taxed?

Earnings within an annuity grow tax-deferred. When you receive payments, the portion representing earnings is taxed as ordinary income. If you withdraw before age 59½, you may also owe a 10% IRS penalty.

What’s the difference between an immediate and a deferred annuity?

An immediate annuity starts paying out income shortly after purchase, while a deferred annuity delays income payments to a future date, allowing for tax-deferred growth.

Should I buy an annuity with my IRA or 401(k) funds?

You can, but it’s often more beneficial to keep tax-advantaged retirement accounts invested and use non-qualified (after-tax) money to purchase an annuity, to avoid double taxation. Consult a professional.

How do I choose the right insurance company for an annuity?

Look for companies with high financial strength ratings from agencies like A.M. Best, Moody’s, S&P, and Fitch, indicating their ability to meet their obligations.

What this page does NOT cover (and where to go next)

• Specific product recommendations for annuities.
• Next: Research specific annuity products and consult with a financial advisor.
• Detailed tax implications for every scenario.
• Next: Consult a qualified tax professional for personalized advice.
• Investment strategies for variable annuity sub-accounts.
• Next: Explore investment management and asset allocation strategies.
• State-specific regulations or annuity protections.
• Next: Review your state’s insurance department website or consult a local advisor.
• The impact of inflation on annuity payments over the long term.
• Next: Learn about inflation hedging strategies and financial planning for a long retirement.