Should I Buy An Annuity?

Should I Buy An Annuity
Elliott Appel, CFP®, CLU®, RLP®

Elliott Appel, CFP®, CLU®, RLP®

Welcome! I'm Elliott, the founder of Kindness Financial Planning, LLC, a fee-only, fiduciary advisor located in Madison, WI working virtually with widows and caregivers across the United States. When I'm not helping people live their ideal life, I'm often cooking for my wife, playing tennis, or hiking.

Last Updated on February 28, 2024

In the financial planning world, annuities can feel like a dirty word. 

They are an extremely polarizing topic. Some people shout from the mountain tops about their benefits while others say never to buy an annuity. 

You might hear phrases like, “Annuities have high fees” or “I bought an annuity for the high guaranteed rate.” It seems like much of the information out there is highly biased or misunderstood. 

That’s no surprise given the number of different types of annuities and the features, or riders, that can be added to an annuity. It’s tough to say whether an annuity is good or bad unless you read the prospectus and have a clear understanding of how it fits within your financial picture. 

Let’s talk about the good, bad, and the ugly of annuities and answer the question, “Should you buy an annuity?” 

Types of Annuities

There are many different types of annuities, which is why it’s difficult when someone asks, “Who should buy an annuity?” to answer or make generalities. While the types differ, so do the features of each annuity. 

Immediate Annuity

An immediate annuity, often referred to as a single premium immediate annuity (SPIA) is an insurance contract where you deposit a lump sum today and receive an immediate series of payments guaranteed for a certain amount of time. 

For example, you might deposit a lump sum in return for monthly payments for the rest of your life. 

Many immediate annuities have different “period certain” options, such as:

  • Life only
  • Life and 10 years certain
  • Life with cash refund
  • 5 year certain

These period certain options contractually guarantee how long you will receive payments. 

For instance, life only will pay until you die. If you die a month after you purchase your annuity, you may only receive one payment and yours heirs get none of your original investment back after you die. 

Life and 10 years certain will make payments for the longer of your life or 10 years. For example, if you die a month after purchasing the annuity, the beneficiary you selected could continue receiving payments for up to 10 years. If you instead lived for 11 years and then died, your heirs would receive nothing because you already received 10 years worth of payments. 

Life with cash refund will make payments for the longer of your life or until your payments have equaled your original investment. For example, if you put $100,000 into a SPIA and only receive $60,000 of payment and then died, your heirs would receive $40,000. 

5 year certain would only make payments for five years and then stop. 

You can customize single-premium immediate annuities with different period certain options. 

The amount you receive may be based on your age, gender, location, period certain, and amount. 

For example, here are quotes for a 70 year old female living in Washington state who wants to put $100,000 into an annuity that makes monthly payments. 

Annuity quotes for 70 year old female in Washington state with $100,000
Quotes from as of 2/28/2024

Here is a quote for a 70 year old male with the same assumptions. As you can see, a male will receive a larger monthly payment for the life options because statistically, males tend to die sooner than females. 

Annuity quotes for 70 year old male in Washington state with $100,000
Quotes from as of 2/28/2024

Pros of Immediate Annuities

Transfer Investment Risk: Since you give up control of the money you are using to purchase the annuity, you are transferring investment risk to the insurance company. When you put money into a SPIA, the funds go into the insurance company’s general account, which is then invested to make payments to you and others. 

No Ongoing Fees: There are no investment fees or regular charges. Any “fees” are baked into the monthly amount you receive. 

Mortality Credits: Mortality credits are created when people die before they earn back what they put into an annuity. Since some people die early, mortality credits exist where the people who live longer get a portion of the benefits of the people who died early. You don’t ever see mortality credits on a statement, but they can exist for people who live longer than life expectancy. 

No Maintenance: Once you buy the SPIA, your income is normally set for life. You don’t need to check on investments or change anything. You’ll receive a regular income for as long as the insurance carrier is in business. 

Cons of Immediate Annuities

Loss of Control: Since you are turning over a lump sum in return for regular payments, you no longer have access to the lump sum. If you decide you need money for a house, gifting, or anything else, you can’t access your money. 

Inflation: Many SPIAs provide a regular payment for a set period of time without an inflation adjustment, which means if you are still receiving payments a decade or two later, inflation may have eaten away at the purchasing power of those dollars. There are SPIAs with inflation adjustments, but many are tied to a specific percentage and not the actual consumer price index change. 

Rate of Return: Since SPIAs are guaranteed payments by the insurance company, they may have a lower rate of return than a balanced stock and bond portfolio. 

Deferred Annuity

Deferred annuities are similar to immediate annuities in that you provide a lump sum today for a regular stream of income, but instead of it happening immediately, it happens at some point in the future.

For example, you might put $100,000 in today and start receiving payments in five years. 

The pros and cons of a deferred annuity are very similar to a single premium immediate annuity.

Fixed Annuity

A fixed annuity is similar to a Certificate of Deposit (CD) in that you are turning over a lump sum of money in return for a specific interest rate that is credited to your annuity amount. 

The downside to a fixed annuity is that typically, your interest rate is only set for one year and then resets annually. Often, the annuity will have a guaranteed minimum interest rate, but your interest rate could go up or down from your first year rate. 

A benefit of a fixed annuity is that earnings are tax-deferred until withdrawn. 

Multi-Year Guaranteed Annuity (MYGA)

A multi-year guaranteed annuity (MYGA) is similar to a CD and your rate is guaranteed for a certain period. 

For example, you could pick a 3 year MYGA and have an interest rate guaranteed for three years. MYGAs are often offered between 2 and 10 years. 

Unlike a traditional fixed annuity, you know what rate you will receive beyond year one. 

Similar to a fixed annuity, earnings are tax-deferred, which means you report income earned at the end of the MYGA period. 

Fixed-Indexed Annuity

A fixed-indexed annuity is an annuity with performance that is tied to a stock market index.

Fixed-indexed annuities often have a floor of 0%, meaning if the stock market index it is tied to returns -30%, the fixed-indexed annuity may have a return of 0% that year. 

They also often have a cap on performance. Sometimes the cap is a percentage, such as 6%, or there is a participation rate, such as 45% of the performance. For example, if it had a cap of 6% and the stock market index returned 10%, you might only earn 6%. If it had a participation rate of 45% and the stock market index returned 10%, you might only earn 4.5%. 

One of the important things to know about a fixed-indexed annuity is that typically the return is of the index only – not dividends, which can often be a good portion of the total return. For example, if the stock market return is 10%, but dividends were 3% of the return, the fixed-indexed annuity may only return 7%, subject to any caps or participation rates. 

Variable Annuity

A variable annuity is an annuity that can invest in stocks, bonds, and other types of investments. 

There are typically no caps or floors, which means you get full participation in the upside and downside. 

Variable annuities often have high fees. They normally have a mortality and expense charge (M&E) and investment expenses. Depending on the annuity, it may only offer higher expense funds around 1%. 

For example, I analyzed an annuity the other day from a major insurance carrier that had an M&E expense of 1.6% and an average mutual fund fee of 0.88%, which meant the investor was paying 2.48% per year in this annuity. It also had an 8 year surrender charge schedule, which meant if they wanted to take their money out within the first 8 years, they would have paid between 8% and 2% of their balance. 

Variable annuities are tax-deferred products, which means you only pay ordinary income on withdrawals, but the downside is that all withdrawals start with your gain, meaning you pay ordinary income tax on withdrawals first before a return of your cost basis, or what you put into the annuity.

For example, if you put $200,000 into a non-qualified annuity that grew to $300,000, the first $100,000 of withdrawals would be taxed as ordinary income before you could get to your original $200,000 without tax consequences. 

Below is a chart to help visualize the difference between the annuities. Please note that each annuity is unique, which means these are estimates. You should ask any insurance agent trying to sell you an annuity how the annuity works, what fees are involved, and their commission. 

Type of AnnuityPossible InterestPossible RiskPossible FeesAgent’s Possible Commission
ImmediateN/ALowerN/A, baked into regular payment1 – 3% 
DeferredN/ALowerN/A2 – 4%
FixedResets annuallyLowerN/A, baked into interest rate1 – 3%
MYGASet for a period of timeLowerN/A, baked into interest rate1 – 3%
Fixed-IndexedUsually a floor and a cap/participation rateMediumN/A, baked into the floor and cap/participation rate3 – 10%
VariableSubject to investments you selectHigher0.50% – 4%4 – 8%

Taxation of Annuities

How an annuity is taxed depends on whether it is qualified or non-qualified and whether you take withdrawals or annuitize it (elect a regular income payment for life or period certain). 

Qualified vs. Non-Qualified Annuities and Withdrawals

Qualified annuities are annuities bought within a retirement plan, such as an IRA, 401(k), or other tax-deferred vehicle. Since retirement plans are already tax-deferred, there is no additional tax benefit.  

Qualified annuities are generally taxed like retirement plans, in that earnings are tax-deferred and withdrawals are normally taxed as ordinary income. You also generally must start taking distributions at age 72. 

Non-qualified annuities are bought with after-tax dollars, which means earnings are tax deferred and only the earnings are taxable when withdrawn. 

Please note that non-qualified annuities operate on a last in, first out (LIFO) basis, meaning earnings are withdrawn first, and then what you put into the annuity, your cost basis, is withdrawn last. In practice, this means any withdrawals are taxed up until you withdrawal all the earnings from the annuity, and then you can access your contributions tax free.

For example, if you put $50,000 into an annuity and it grows to $80,000, your first $30,000 worth of earnings is taxed as ordinary income before you can withdraw the $50,000 you contributed without paying taxes. 

Also, there are no required minimum distributions with a non-qualified annuity as there are with a qualified annuity. 

Lastly, any withdrawals prior to age 59 ½ generally have a 10% early withdrawal penalty on top of the tax treatment. 


If you choose to annuitize and take a regular income stream from the annuity, the taxation is based on the exclusion ratio

The exclusion ratio is the percentage of how much you contributed compared to the total value today. In other words, it’s the percentage not subject to tax. 

For example, if you contributed $150,000 to an annuity and it grew to $200,000, at which point you annuitized it, your exclusion ratio would be 75%. This means that 25% of each annuity payment would be taxable. If you had a monthly payment for life of $1,400, that would mean $350 of each payment would be taxable and $1,050 would be non-taxable. 

Note: If you annuitize a qualified annuity that only has pre-tax money, you may pay taxes on the full amount of each payment because you have no after-tax cost basis in the annuity. The exclusion ratio tends to come into play only with non-qualified annuities. 

Annuity Rates of Return Examples

Single Premium Immediate Annuity (SPIA) Rate of Return Example

Annuities are often marketed in a way that makes it difficult to determine the rate of return you may earn. Let’s go through one simple example with a SPIA. 

Some people will quote the “annuity rate” or “payout rate” as a percentage. For example, the SPIA may have a 6% payout rate. That 6% is not your rate of return. It’s the amount you may receive annually. For instance, if you put $100,000 into a SPIA that had a 6% payout rate, it may pay you $6,000 per year. 

If it’s a life only annuity, you need to receive payments for over 16 years before you start earning a positive rate of return ($100,000 divided by $6,000). In other words, you are only spending your own money for the first 16 years. Only after that are you starting to spend some of the insurance company’s money. Even after 25 years, your internal rate of return is still about 3.4%. As of this writing, there are 20 year treasury bonds with a yield-to-maturity of about 3.8%.

If you want to do your own calculation for annuity quotes, you can do it using this annuity calculator

Guaranteed Living Withdrawal Benefit Riders

Another type of product that makes it difficult to calculate actual rates of returns are variable annuities with living benefit riders that provide retirement income guarantees. 

They are less popular today, but in the years after the 2008 financial crisis, they gained popularity. I imagine they will regain popularity at some point in the future. 

I won’t go into detail about the math and rates of returns behind these products, but I do want to point you to a resource to learn more. Kitces has an excellent write up describing the rate of return behind these products. 

Remember, if the rate of return seems too good to be true relative to the risk, there is a good chance of the following:

  • It’s a scam or fraud.
  • Someone isn’t explaining it well.
  • You are misunderstanding.

If it’s a scam, walk away. In the other two scenarios, you can decide whether it’s better to walk away or stay and ask more questions.

Who May Want to Buy An Annuity?

As you can see, there are many different types of annuities. 

Generally, the simpler the annuity, the better. Annuities with many different features or riders and longer surrender charges may be more costly over time without added benefits. 

Annuities aren’t right for everyone. Below are a few scenarios where an annuity might make sense. 

Conservative Investors

If someone has a very conservative appetite for risk and may keep their portfolio in mostly cash or bonds, a single premium immediate annuity could make sense for them. 

There is comfort in knowing you have a regular payment coming into your bank account.

There are no investment statements. No ups or downs in the market. No rebalancing your portfolio. 

As long as the insurance company is in business and has the funds, you should receive your regular annuity payment. 

For some people, no amount of education, investment policy statement, or experience in the stock market is going to help them invest, in which case a SPIA can make sense. 

Also, there are some people who want to have a certain level of income for living expenses, which gives them more confidence to invest more aggressively in their remaining funds. A SPIA can help them achieve it. 

People Worried About Longevity

For people who are worried about outliving their money or expect a long life expectancy, a SPIA can have attractive rates of return for those who live a long time. 

As we talked about earlier, the rates of return are usually not very good for someone with below average or near normal life expectancy, but as you grow older and continue receiving those regular payments, the internal rate of return can be attractive. 

Plus, you don’t have to worry about your investment portfolio going up or down. 

Over Age 59 ½ and Want to Park Cash Somewhere

For those people looking for a place to park their cash they don’t need access to, they could consider a multi-year guaranteed annuity (MYGA). The rates may be higher than CDs or other bonds.

While the risk is slightly higher because a CD may be FDIC-insured, some people are okay taking a little more risk with the insurance company to potentially earn a higher rate of return

Since annuities may have a 10% early withdrawal penalty for people who take withdrawals prior to age 59 ½, generally, a MYGA won’t make sense for someone who is much younger than age 59 ½. 

People with Family Members Who Have Trouble Managing Money

If you have a family member who has trouble managing money, and you don’t want to deal with being a trustee of a trust or hiring a corporate trustee, you could consider purchasing an annuity for them that pays a regular payment. 

This can be helpful if they have trouble managing a large sum of money, but would do okay with a payment that could help support their lifestyle. 

Who May Not Want to Buy an Annuity?

An annuity is often not needed for a successful retirement. Normally, I come from a place where there needs to be a very good reason to purchase an annuity. By default, many people don’t need them. Below are a few scenarios where it may not make sense to buy an annuity. 

Don’t Understand What You Are Buying

I’ve met many people who have bought annuities they don’t fully understand, which is easy to do because they are complex financial products where each contract is unique. 

If you can’t explain it to another person and have them fully understand, I wouldn’t buy it. 

Already Have Enough Income for Retirement

If you already have enough income from Social Security, pensions, or portfolio income, I see no point in adding on additional income that will be taxed. 

There may be better ways to leverage those dollars for your ideal life. 

People with Shorter Life Expectancies 

Annuities are meant to help provide income for life. For people with shorter life expectancies, it rarely makes sense to buy an annuity. 

The rate of return is often low or potentially negative if you die early. 

Final Thoughts – My Question for You

Annuities are complex financial products. Each annuity is different and can often come with added riders that make them more difficult to understand or clearly know what you are paying. 

Not all annuities are bad, despite what others say. Not all annuities are good, despite what an insurance person may say. 

Annuities can serve their place in a retirement portfolio under the right circumstances. The key is to understand what you want to accomplish and how the annuity will serve that purpose, if at all. 

As you think about whether to buy an annuity, consider the advantages and disadvantages of each annuity, taxation, fees, access to your money, inflation, and other factors. 

I’ll leave you with one question to act on. 

Does an annuity fit within your financial plan? 

Disclaimer: This article is for general information and educational purposes only and should not be considered investment, financial, legal, or tax advice. It is not a recommendation for purchase or sale of any security or investment advisory services. Please consult your own legal, financial, and other professionals to determine what may be appropriate for you. Opinions expressed are as of the date of publication, and such opinions are subject to change. Click for full disclaimer.

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