How do annuities work? You pay a premium to an insurer, and the carrier credits growth under the contract. You later take that money as withdrawals, a lump sum, or income. A large early withdrawal is hard to undo while the insurer's charge applies, and so is annuitization on many contracts.
That premium is usually a rollover from a workplace plan or after-tax savings you do not want in the market. At Local Life Agents, we check the credit and the withdrawal rules before any premium is funded. We also check whether the income choice is permanent.
Key Takeaways
- Insurance contract. An annuity is a contract with an insurer, so premium is credited under written rules rather than held as shares in a fund.
- Two phases. Accumulation is when you pay in and growth is credited tax-deferred; distribution is when you withdraw, take a lump sum, or annuitize.
- Surrender window. A free withdrawal is usually allowed each year, and a charge on the excess steps down until the surrender period ends.
- Usually irrevocable. Annuitization trades the account for a payment stream, and you generally cannot reverse that election.
- Product type. Fixed, multi-year, indexed, and immediate contracts do not credit growth or start income the same way.
How does an annuity's accumulation phase work?
You pay premium in, and the insurer credits growth while that money stays in the contract. On a fixed contract the carrier holds the premium in its general account, its own portfolio, and credits a stated rate rather than that portfolio's return. On an indexed contract the credit follows an index formula, not the index's full gain. Either credit is tax-deferred until you take money out.
Most deferred contracts let you withdraw about 10% a year with no surrender charge. Anything above that free amount incurs a surrender charge on the excess. The charge is highest early and steps down to zero when the surrender period ends.
A free-look period, often 10 to 30 days after issue, lets you cancel if the contract is not what you expected. Cancel inside that window and the carrier returns your premium.
How does an annuity's distribution phase work?
You take money out as withdrawals, a lump sum, or by annuitizing the contract. Withdrawals and a lump sum leave the rest of the account in place. Annuitization trades the account for a payment stream, and that trade is usually irrevocable.
A single-premium immediate annuity skips a long accumulation period. You pay one premium, and income starts soon after issue. The income form is chosen up front and is usually permanent.
How do the parties on an annuity contract differ?
The owner controls the contract, the annuitant is the measuring life for income, and the beneficiary is who gets paid at death. Those three jobs can sit with one person or with different people.
If the owner and the annuitant are different people, each death is a separate event under the contract. The contract says who is paid for each one.
If you die during accumulation, the beneficiary generally receives the contract value. If you die after a life-only annuitization, payments can stop and the beneficiary may receive nothing.
How does product type change how an annuity works?
Product type changes how an annuity works by changing the credit, when income can start, and what you give up.
| Product type | How growth or income is credited | When you can take income | What you give up |
|---|---|---|---|
| Fixed | Declared interest from the general account | Free withdrawals during surrender; full access or annuitization after | A renewal rate that can fall, and early access above the free amount |
| Multi-year guaranteed (MYGA) | One guaranteed rate for the full term | Free withdrawals during the term; full value when it ends | A higher credit if rates rise before the term ends |
| Indexed | An index formula with limited gains and a floor against index loss | Withdrawals under the surrender schedule, or income if you annuitize | Gains above the formula |
| Single-premium immediate (SPIA) | Premium converts directly to income | Soon after the premium is paid | The account, and usually the right to change the income form |
Each contract is spelled out on the annuity types page.
Before you commit
How an annuity works depends on which phase you are in. Accumulation means the money stays in the contract and grows. Distribution means the premium is becoming income. Those are not two settings on the same policy you can flip later without a cost.
Before we illustrate a contract, we lock four things:
- Phase. Grow first, or income now. A SPIA skips accumulation. A MYGA or indexed annuity is still in it.
- Surrender schedule. Free withdrawals are a slice. The rest of the premium is tied up for the term.
- Who is on the contract. Owner, annuitant, and beneficiary are different jobs. The death benefit follows that setup.
- Tax bucket. Non-qualified growth waits until you withdraw. Qualified money follows the retirement account.
Tell us whether you are growing the money or spending it, and when. We illustrate the type that matches that phase.
How are annuity withdrawals taxed?
Annuity withdrawals are taxed as ordinary income on the gain. After-tax, or non-qualified, contracts generally tax that gain before your premium comes back out, and IRA or rollover money follows retirement-account rules. The annuity taxation guide covers those rules in full.
Expert Tip: Decide liquidity before you chase yield
I see people chase a rate or a cap, then need cash in year three of a seven-year surrender schedule. The free withdrawal covers only a slice of the account. The rest still carries a surrender charge that has stepped down but has not hit zero, so the check is smaller than the statement value. I map those middle-year cash needs before we look at the credit.
—Ryan Wood
Who is an annuity for?
An annuity is for someone who can leave the premium through the surrender period and wants the insurer to credit growth or pay income. A rollover, or cash you will not spend in full for several years, is the usual case.
It also fits when the job is income you do not want to manage year to year. That only works if you can accept that annuitizing may be permanent.
Who should not buy an annuity?
Do not buy an annuity if you need the full balance while a surrender charge still applies. The free withdrawal will not cover a large bill. The statement value is not the amount you would receive after the charge.
Also skip a life-only annuitization if heirs are supposed to receive the account. Skip the contract if you want market gains the crediting method does not pay.
The trade is tax-deferred credit and a path to income, in exchange for surrender limits and an election that can be permanent.
Pros
- Tax-deferred growth while the contract stays in force
- Carrier-credited growth rather than a stock-fund balance
- Withdrawals, a lump sum, or annuitization as ways to take money out
- A free withdrawal amount on many deferred contracts
- Contract value generally paid at death before you annuitize
Cons
- Surrender charges on withdrawals above the free amount
- Annuitization that is usually irrevocable
- Gains taxed as ordinary income when withdrawn
- Life-only income that can leave nothing at death
- Less access to the full balance than a bank or brokerage account
Conclusion
We see premium funded for the credit on page one, then the owner discovers the balance cannot come out cleanly. A single-company packet shows only that company's surrender rules and whether annuitization is permanent.
We place the same premium with 30+ A-rated carriers so you can see what is still reversible after issue. Start that comparison from the annuities hub.
FAQ
Annuities
See how your premium would move through the contract before you fund.
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