Glossary
Annuity
An annuity is an insurance contract that converts a lump sum into a stream of payments, starting now (immediate) or later (deferred). It is the only retail product guaranteeing income for life, and the fee schedule is where the cost hides.
What it is
An annuity is an insurance contract that trades a lump sum for a stream of payments, either starting immediately (an immediate annuity) or at a future date (a deferred annuity). The product types divide by what the money does: fixed annuities pay a set rate, fixed-indexed annuities track an index with caps, and variable annuities hold funds with market exposure. The core mechanic is the mortality credit: payments to those who die early fund larger payments for those who live long.
A 70-year-old converting $200,000 into a simple immediate annuity locks roughly $1,300 a month for life, about 7.8% a year, which no bond yield matches. The complexity is where the cost lives: variable annuities commonly carry 2-3% or more in annual fees, and state guaranty associations cap protection per insurer at roughly $250,000. Simple contracts are the longevity hedge; complicated ones are the fee engine.
Key takeaways
- Immediate annuities convert a lump sum into lifetime income; $200,000 at 70 pays roughly $1,300 a month.
- Variable annuities layer market exposure on top and commonly carry 2-3% or more in annual fees.
- The mortality credit is the math: early deaths fund larger payments for long lives.
- Simple SPIAs are the clean longevity hedge; riders and index features are where fees live.
- State guaranty associations cap coverage per insurer, typically $250,000, so insurer strength matters at scale.
How it works
The pricing is actuarial: the insurer combines the premium, current interest rates, and a mortality table into a payout. A 70-year-old's $200,000 immediate annuity pays roughly $1,300 a month for life because half the cohort funds the other half; the mortality credit is the return no bond offers. The payout rate looks like a yield and is not: part of every payment is the buyer's own principal coming home. Deferred annuities accumulate first and annuitize later, with the deferral itself a form of tax-sheltered growth inside the contract.
Taxation follows the exclusion ratio: each annuitized payment splits into a tax-free return of principal and taxable ordinary income, with no capital gains treatment. A $200,000 premium paying $15,600 a year over a 20-year expectation returns 64% of each payment as principal. Riders reprice everything: inflation protection, death benefits, and guaranteed lifetime withdrawal benefits each add 0.5% to 1.5% annually. Surrender periods of six to ten years lock exits behind surrender charges that start near 7% and decline to zero. Variable annuity fees stack on top: mortality and expense charges, fund expenses, and riders commonly total 2-3% or more a year.
Why it matters
The annuity is the only retail product that guarantees income that cannot be outlived, which makes it the direct hedge for longevity risk next to delayed Social Security. For the slice of retirement spending that must never stop, the mortality credit is a return no portfolio offers.
I watched a colleague named Brent (yes, that Brent) roll a $250,000 IRA into a variable annuity with a 3.1% fee stack, buying tax deferral inside an account that was already tax-deferred. The fees cost roughly $390,000 of balance over 20 years at a 6.5% gross return. He paid a premium for a benefit he already had.
The highest-leverage thing most Americans can do is skip the complexity: if lifetime income is the goal, buy the simple immediate annuity and price the riders separately. Model the payout with the immediate annuity calculator and the accumulation with the annuity calculator. The mortality credit is worth paying for; the fee stack is not.
Real-world examples
The SPIA: $200,000 into lifetime income at 70
A 70-year-old man converting $200,000 into a single-premium immediate annuity locks roughly $1,300 a month for life, about 7.8% a year, against a 4% portfolio draw of $667. The trade is the principal: no inheritance, no liquidity, no market upside. For spending that must never stop, the mortality credit is the return no bond matches. The math confuses people who read the payout like a bond yield: roughly $830 of each month's payment is the buyer's own principal coming home, and only the remainder is true income.
The variable annuity fee stack: 3.1% a year
A $250,000 variable annuity at a 6.5% gross return nets 3.4% after 3.1% in mortality, expense, and rider charges. Over 20 years that compounds to roughly $488,000 against $881,000 in a low-cost index fund: a $393,000 fee gap. Inside an IRA, the contract's tax deferral adds nothing the account already provides.
The exclusion ratio: how annuity income is taxed
A $200,000 premium paying $15,600 a year over a 20-year life expectation returns 64% of each payment as tax-free principal: $10,000 excluded, $5,600 taxable as ordinary income. At the 22% bracket, the tax is roughly $1,230 a year. There is no capital gains treatment anywhere in the contract; annuity gains are always ordinary income. Past the life expectancy, every payment is pure gain with the principal long since returned, which is the mortality credit at full throttle and the reason the contract is priced against a mortality table.
Common mistakes
Mistake: Buying a variable annuity inside an IRA.
Why it bites you: The tax deferral is already free in the IRA; the 2-3% annual fee buys a benefit the account already has, at roughly $390,000 over 20 years on $250,000.
Mistake: Ignoring the surrender period before signing.
Why it bites you: A 7-year schedule charging 7% declining to 0% locks $200,000 behind a $14,000 exit fee in year one, before the 10% IRS penalty on gains.
Mistake: Confusing fixed-indexed caps with market returns.
Why it bites you: A 50% participation rate with a 5% cap means an 11% index year pays 5% minus fees; the upside is clipped and the fees are not.
Mistake: Skipping insurer-strength checks at scale.
Why it bites you: State guaranty associations cap coverage near $250,000 per insurer; a $500,000 premium at a weak carrier is concentrated risk, not a guarantee.
Ivy's take
I read the fee schedules on two dozen annuity illustrations so you don't have to, and the pattern is that the mortality credit is the only part of the product worth its price: a simple immediate annuity pays more per dollar than any bond because of it, and every rider dilutes that advantage. My rule is to buy income like insurance, not like an investment: the plainest contract, from the strongest insurer, for the slice of spending that must never stop.
Brent paid 3.1% a year for tax deferral inside an IRA and called it safe. The index fund he did not buy was safer and roughly $390,000 richer over 20 years. Safety that costs 3% a year is a product, not a property.
Related jargon, defined
- SPIA
- A single-premium immediate annuity: lump sum in, lifetime income out.
- Mortality credit
- The return from pooling longevity risk across a cohort.
- Exclusion ratio
- The share of each annuity payment that is tax-free return of principal.
- Surrender charge
- The declining exit fee during the contract's surrender period.
- Variable annuity
- A contract holding funds with market exposure, plus 2-3% or more in typical annual fees.
- QLAC
- A qualified longevity annuity contract inside a retirement account, deferring income to as late as 85.
Frequently asked questions
Are annuities a good investment?+
They are income insurance, not growth: simple immediate annuities are the direct hedge for longevity risk. Variable annuities with 2-3% fee stacks rarely justify their cost inside tax-advantaged accounts.
How are annuity payments taxed?+
Annuitized payments split under the exclusion ratio into tax-free return of principal and taxable ordinary income. Gains inside the contract are always ordinary income when withdrawn, never capital gains.
What happens to my annuity when I die?+
It depends on the contract: life-only payouts end at death, while period-certain or refund options pay survivors at a cost to the payout rate. Riders and their pricing decide the answer.
Can I get my money out early?+
During the surrender period, yes, at the cost of surrender charges that start near 7%. Gains withdrawn before 59½ also owe the 10% IRS penalty unless an exception applies.
How much does a $100,000 annuity pay per month?+
For a 70-year-old man buying a simple immediate annuity, roughly $650 a month for life, about 7.8% a year. Rates move with age, interest rates, and the payout options chosen.
Disclaimer: This information is general in nature and does not constitute financial or legal advice. Always consult a qualified professional for your specific situation.
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Ivy Sinclair-Wren
Financial Chaos Analyst
Ivy Sinclair-Wren is a Financial Chaos Analyst covering investing, AI, wealth psychology, and the emotional consequences of opening finance apps during market crashes. Based in Melbourne, she specializes in demystifying the US tax code and helping users navigate the intersection of spreadsheet logic and human irrationality.