Let me ask you a question. For as unpredictable as the stock market is, should your retirement income be unpredictable too?
We don’t think so. And that’s really the whole reason annuities exist. So how does an annuity work? In plain English: you position a portion of your savings with an insurance company, and in exchange, that company gives you guarantees. Guarantees against market loss, guarantees of income you can never outlive, or both. That’s it. That’s the core of it.
Now, I know what some of you are thinking, because we hear it in our office every single week. “Aren’t annuities bad?” Folks, an annuity is a tool in the tool belt, just like anything else. There are stocks that aren’t the best fit for people. There are bonds that aren’t the best fit for people. And yes, there are annuities that aren’t the best fit for people. That doesn’t mean you eliminate the whole category. It means you have to understand how the tool works before you decide whether it belongs in your plan.
That’s what this guide is for. We’re going to walk through what an annuity actually is, how the different types work, who they’re for (and who they’re not for), how we use them inside a bucketing strategy in our office, and the misconceptions that keep people from even having the conversation. By the end, you’ll know more about annuities than most people ever learn, and you’ll know exactly what questions to ask before you put a single dollar into one.
What Is an Annuity, in Plain English?
An annuity is a contract between you and an insurance company. You put money in, either a lump sum or a series of payments, and the insurance company makes you a promise in return. Depending on the type of annuity, that promise might be:
- A guaranteed rate of interest on your money, a lot like a CD
- Protection of your principal from market losses, with the opportunity to grow when the market goes up
- A guaranteed monthly paycheck for the rest of your life, no matter how long you live
Here’s the way I like to frame it. Think about the people who retired a generation or two ago. Many of them had a pension. They worked 30 years, they retired, and every single month, a check showed up. They didn’t watch the market. They didn’t worry about a 4% withdrawal rate. The money just came in.
Those pensions are largely gone now. Most of you reading this have a 401(k), a 403(b), a TSP. A pile of money instead of a paycheck. Which means when you retire, you become your own pension manager. You’re tasked with turning that pile into income that lasts 20, 30, maybe 40 years, while navigating taxes, inflation, and market volatility the whole way.
An annuity is one of the few tools that lets you hand part of that job back. It lets you privatize your own pension, turning a portion of your personal savings into the kind of predictable, guaranteed income that used to come standard with a career.
How Does an Annuity Work? The Mechanics, Step by Step
Every annuity, no matter the type, works in the same basic sequence. Let’s walk through it.
Step 1: You fund the contract
You purchase the annuity with a premium. That might be $100,000, $250,000, $500,000. Whatever amount makes sense for the job you’re asking the annuity to do in your plan. (More on how we size that later, because this is where most people get it wrong.)
Step 2: The money grows: or waits
With a deferred annuity, your money sits in the contract and grows over time before you ever take income. How it grows depends on the type: a fixed rate, an index-linked crediting method, or market investments. With an immediate annuity, there’s no waiting. Payments start right away, typically within a year.
Step 3: You take income or withdrawals
When you’re ready, the annuity starts doing its real job: sending money out. That might be a guaranteed lifetime income stream, structured withdrawals, or simply pulling interest. And this is where the magic is for retirees. Some of these contracts will keep paying you even if the account balance itself runs out. As long as you’re breathing, the check keeps coming.
The fine print that matters
Now, if I could give you all of the upside with no downside and no strings attached, that would qualify as too good to be true, right? There’s always a trade-off. With annuities, the big ones are:
Liquidity. Annuities are typically long-term contracts. You can’t get to all of your money all at once the way you could with a stock or an ETF. Most contracts let you withdraw a portion each year (often 10%) without penalty, but pull out more during the surrender period and the insurance company may assess a surrender charge.
Guarantees depend on the insurer. Annuity guarantees are subject to the claims-paying ability of the issuing insurance company. That’s why the financial strength of the carrier matters just as much as the rate they’re offering, something we cover in depth in our guide to annuity rates in 2026 and how to compare them [LINK].
Growth is usually capped or limited. Protection costs something. Usually what it costs is a piece of the upside.
If you understand those three things, you understand annuities better than 90% of the people who own one.
The Main Types of Annuities (and Which Ones We Actually Use)
Annuities come in several flavors, and the differences matter a lot. Here’s the landscape.
Fixed Annuities
A fixed annuity is a guaranteed contract with no downside potential. It pays you a specified rate of interest over a set period, say, a three-year or five-year contract, a lot like a CD does, with the interest typically tax-deferred until you take the money out. If you’re a conservative investor looking for something guaranteed and simple, this is the most straightforward option on the menu. In today’s rate environment, these have become genuinely competitive again, which is a big change from a decade ago, when parking safe money meant earning 1% or 2% and effectively losing money safely to inflation.
Fixed Indexed Annuities (FIAs)
This is the one that tends to be the most popular in our office, and it’s worth understanding why. A fixed indexed annuity gives you a combination: your money is linked to a market index, say, the S&P 500, so when the index goes up, you have the opportunity to capture a percentage of those gains. But if the market goes down? You cannot lose any money due to that market decline. Some upside, with absolutely no downside.
The trade-off, because there’s always a trade-off, is that you won’t capture all of the growth. There are participation rates, caps, and other performance metrics that limit your upside in exchange for eliminating your downside. And here’s the part I like the most: many of the fixed indexed annuities we use have little to no fees.
This product deserves its own deep dive, so we wrote one: how fixed index annuities work and who they’re for [LINK].
Variable Annuities
A variable annuity is not guaranteed. Your money is invested in market-based subaccounts, so it can go up and it can go down, and these contracts are often where the annuity industry earned its reputation for high, layered fees. There are situations where they fit, but candidly, they’re not the type we typically use in our office. If you’re weighing the two, we break down the differences in our comparison of fixed vs. variable annuities [LINK].
Immediate Annuities
This is the annuity your grandparents used. You take a lump sum of money, you give it to an annuity company, and in exchange, they give you a monthly income for the rest of your life, starting now. Simple, powerful, and for the right situation (replacing a pension, converting a windfall into a paycheck), still very relevant. We cover payout options, how payments are calculated, and who’s a fit in our guide to immediate annuities and turning a lump sum into guaranteed income [LINK].
Deferred Annuities
A deferred annuity is any annuity where the income starts later. You fund it today, it grows, and the paycheck begins years down the road. This is how we bridge known future income gaps: we know a gap is coming at 62 or 65, so we position money today that’s guaranteed to fill it when it arrives. Here’s how deferred annuities work and when to use one [LINK].
Who Should Consider an Annuity (and Who Shouldn’t)
Let’s be honest about something: we are not out here saying that every single person should own an annuity. There are plenty of people it doesn’t make sense for, and we’ll tell you that very directly. But there are three profiles where annuities consistently earn their place in a plan.
1. You have an income gap. You’ve mapped out money coming in (Social Security, maybe a pension) against money going out (your actual lifestyle), and the income doesn’t cover the outgo. That gap has to be filled from your savings, and an annuity can fill it with a guarantee instead of a hope.
2. You don’t have a pension. If Social Security is your only guaranteed income source, everything else in your retirement rides on the market. An annuity lets you build a second layer of guaranteed income underneath your plan. What we call an income floor. Imagine waking up every morning in retirement knowing that no matter what happens in the stock market, your essential expenses (housing, food, health care) are completely covered by an income stream that will be there for the rest of your life, and potentially your spouse’s life too. That’s the power of the right annuity in the right plan, and it’s the heart of our income floor strategy for retirement annuities [LINK].
3. You can’t stomach the volatility: or your plan can’t. Some folks simply cannot watch their life savings swing $50,000 in a week, even if it comes back the next week. Others have a plan that mathematically cannot withstand large market losses while they’re actively drawing money out. Both are legitimate candidates.
We had a gentleman come in with about $1.8 million, and on $800,000 of it he was very specific: “I am sick of looking at my account week to week and losing $20,000, $50,000 in a week, even if I gain it back.” So we took that $800,000, put it into a fixed indexed annuity, and now he never has to worry about losing money due to a market decline again. The market goes up, he gets some modest returns. The market goes down, he doesn’t lose a penny to it. And the rest of his money? Still invested, still growing, but now he doesn’t feel like all of his eggs are in one basket.
How We Use Annuities Inside the Bucketing Strategy
Here’s where the rubber meets the road, because an annuity should never be a random purchase. It should be a specific tool doing a specific job inside a coordinated plan. In our office, that plan is built around buckets.
To us, retirement is a function of money coming in and money going out. So we separate your assets into buckets based on time horizon and the job each dollar has to do:
The blue bucket: short-term operational money. Checking, savings, CDs, T-bills. This is the money funding your lifestyle right now. We’re not chasing returns here; we’re keeping it liquid and safe.
The green bucket: the pension bucket. This is where income is manufactured with no downside potential. Annuities live here, alongside bond ladders and CD strategies. This bucket’s job is simple: guaranteed income, regardless of what the market does.
The red bucket: the growth bucket. Stocks, growth investments, the money hedging inflation and building your legacy. Because the blue and green buckets have your income covered, this bucket can afford to ride out the market’s ups and downs.
Let me show you what this looks like in real life. A couple came into our office at 58 years old. They’d just sold their business for a million dollars, and one of them had a pension. To retire the way they wanted, they needed $10,000 a month after taxes. The pension got them to about $4,000. That’s a $6,000-a-month gap, and even with a million dollars in the bank, $6,000 a month can eat into that money in a significant way. No wonder they were anxious.
Here’s what we did. At 62, their combined Social Security would bring in about $5,000 a month, so we knew the big gap was temporary, a four-year bridge. We took $300,000 and put it in the blue bucket. Short-term instruments to pay out that $6,000 a month until Social Security kicks in. We took $250,000 and put it into the green bucket using an annuity, guaranteed to close the remaining gap of roughly $2,000 a month from age 62 for life, no market risk, just a guaranteed paycheck. And everything else went into the red bucket to grow.
When she saw how bucketing the money closed the gap, she looked at me and said, “I finally feel like I can stop worrying about whether it’s okay to enjoy my life.” As an advisor, that is by far the coolest conversation to have. You can hear us walk through that full case study on Episode #198 of Retire Smart Maryland Radio. [LINK to radio archive]
The Pros and Cons of Annuities
Let’s put it all on the table, because a fiduciary doesn’t sell you the highlight reel.
The pros
- Guaranteed lifetime income. The only financial tools in America that can guarantee you a paycheck for life are Social Security, a pension, and an annuity. That’s the list.
- Principal protection. With fixed and fixed indexed annuities, market declines cannot touch your principal.
- Tax deferral. Growth inside an annuity isn’t taxed until you take it out, which can be a meaningful planning lever in non-qualified accounts.
- A smoother ride. One client of ours had $1.4 million in his IRA and worried about taking required minimum distributions in a down market. We split it. Half into a fixed indexed annuity, half staying in the market. Market’s up? RMD comes from the market money. Market’s down? RMD comes from the annuity, which didn’t lose a dime. He might not get maximum growth, but he gets a heck of a lot of peace of mind. (Episode #157 covers this strategy in detail [LINK].)
The cons
- Liquidity limits. Long-term contracts, surrender periods, and surrender charges are real. Never put money into an annuity that you might need back in full next year.
- Capped growth. An annuity should never be your primary growth vehicle. That’s not its job. Its job is protection and income.
- Fees on some products. Some annuities carry riders and expenses worth every penny for the guarantee they buy; others are, frankly, egregious. I call the hidden ones “internal fees”. They’re like financial termites, quietly eating at your principal until you look up 15 years later asking where all your money went. Know what you’re paying, internally and externally, before you sign anything.
- Complexity. Caps, participation rates, riders, crediting methods. The industry hasn’t made this easy. (It’s also why comparing offers matters so much; see our breakdown of how annuity rates work and what’s competitive in 2026 [LINK].)
And if you’re comparing an annuity against the other safe-money option everyone knows, we’ve done that head-to-head too: annuity vs. CD [LINK], which provides better returns.
Common Annuity Misconceptions, Corrected
“Annuities are bad.” Annuities have been unfairly stereotyped based on the annuities of old. The high-fee, hand-over-your-money-and-hope contracts from decades ago. The product category has changed in a major way. Many of the fixed indexed annuities we use today have no fees at all and never require you to give up your principal.
“If I die early, the insurance company keeps my money.” That was true of some old-style immediate annuities. Today, most contracts offer payout options and death benefits that pass remaining value to your beneficiaries. It’s a choice you make when you structure the contract, not a built-in trap.
“My advisor made a face when I mentioned my annuity, so it must be a mistake.” John had a client come in for a review. Her fixed indexed annuity is set up to provide her and her husband with close to $80,000 per year of guaranteed income for as long as either of them is alive, even if the funding amount runs out. Her nephew, brand new to the financial industry at a growth-focused firm, cringed when she told him. Why? Because his firm’s clients are young accumulators who don’t need income protection. The tool wasn’t wrong. The perspective was just built for a different job. (This story is on Episode #201. [LINK])
“I already have an annuity, so I’m set.” Maybe. But if you bought an annuity in 2012 or 2015, when rates were 1% or 2%, it may have been the best thing available then, and there may be dramatically better rates, features, and carrier strength available now. That doesn’t automatically mean replace it. It means every annuity owner should periodically re-evaluate whether the contract is still working the way you intended. Sometimes the honest answer is “keep it right where it is.”
Frequently Asked Questions About How Annuities Work
How does an annuity work when I retire: do I have to “annuitize”?
Not necessarily, and this surprises people. Many modern contracts, especially fixed indexed annuities, let you take income through withdrawals or income riders while you keep control of the principal. Annuitizing, permanently converting the balance into payments, is one option, not a requirement.
Can I lose money in an annuity?
In a fixed or fixed indexed annuity, you cannot lose money due to a market decline. Period. Where people can lose money is surrender charges from pulling out early, or fees on the wrong product. In a variable annuity, yes, market losses are absolutely possible. Know which type you’re looking at.
How much of my portfolio should go into an annuity?
Only as much as the income job requires. In our office we work backwards: figure out the monthly income gap, then size the annuity to close that gap. For one client, that meant carving out $300,000 of a $1.5 million portfolio (about 20%) to create a steady paycheck for life. Not 100%. Never 100%. An annuity is one puzzle piece, not the whole puzzle.
What happens to my annuity when I die?
It depends on how the contract is structured. Joint payout options can continue income for your spouse’s lifetime. Death benefit provisions can pass remaining value to your kids. This is exactly the kind of thing to decide on the front end, with someone who’s legally obligated to put your interests first.
Are annuity payments taxable?
If the annuity is inside an IRA or funded with pre-tax dollars, withdrawals are taxed as ordinary income, just like any other IRA distribution. If it’s a non-qualified annuity funded with after-tax money, only the earnings portion is taxed. And remember: withdrawals before 59½ may face tax penalties on top of income taxes.
How is an annuity different from just keeping money in the bank?
The bank gives you liquidity and FDIC insurance; it does not give you lifetime income, and in low-rate stretches it quietly loses to inflation. What I call losing money safely. An annuity trades some liquidity for guarantees the bank can’t make. Different tools, different jobs.
Is an annuity better than a 401(k) or IRA?
Wrong question. It’s not either/or. Your 401(k) and IRA are accounts; an annuity is a tool that can even live inside those accounts. The real question is whether some portion of your retirement money should be doing the guaranteed-income job instead of the market-growth job.
The Next Step: Find Out If You Have an Income Gap
Here’s the truth, folks. The question is never “are annuities good or bad?” The question is: when you retire, will your money coming in cover your money going out, guaranteed?
If the answer is yes, congratulations. You may not need an annuity at all, and we’ll be the first to tell you that. If the answer is no, or “I honestly don’t know,” then that gap is the single most important number in your retirement, and you deserve to know it before you retire, not after.
That’s why we offer a complimentary income gap analysis. We’ll sit down with you, map out every income source against your real lifestyle costs, run your Social Security optimization, and show you, bucket by bucket, exactly where a guaranteed income tool does or doesn’t belong in your plan. No cost, no obligation, and you’re leaving the checkbook at home.
Call 800-653-8404 to schedule your income gap analysis with the fiduciary team at Elite Income Advisors, or visit us at our Ellicott City or Annapolis office. For as unpredictable as the market is, your retirement income shouldn’t be.
Prefer to listen first? Hear Prashant break the whole bucketing-and-annuities approach down on Episode #198 of Retire Smart Maryland Radio. [LINK to radio episode]
Disclosures:
- Investment advisory services offered through Elite Income Advisors, Inc., a registered investment advisor located in Ellicott City, Maryland. The firm only conducts business in states and jurisdictions in which they are properly registered or exempt from registration requirements. Registration is not an endorsement of the firm by securities regulators and does not mean the advisor has achieved a specific level of skill or ability.
- Neither Elite Income Advisors, Inc. nor Retirement Planning Services, Inc. is engaged in the practice of law or accounting. Always consult an attorney or tax professional regarding your specific legal or tax situation. Tax information provided is general in nature and should not be construed as legal or tax advice. Tax rules and regulations, as well as inflation rates, are subject to change at any time.
- Information presented is believed to be current. It should not be viewed as personalized investment advice or as an offer to buy or sell any of the securities discussed. All expressions of opinion reflect the judgment of the author on the date of publication and may change in response to market conditions. You should consult with a professional advisor before implementing any strategies discussed.
- All investment and insurance strategies have the potential for profit or loss. Different types of investments involve higher and lower levels of risk. There is no guarantee that a specific investment or strategy will be suitable or profitable for an investor’s portfolio. There are no assurances that an investor’s portfolio will match or exceed a specific benchmark. Asset allocation, rebalancing, and diversification will not necessarily improve an investor’s returns and cannot eliminate the risk of investment losses.
- Insurance and annuity products are sold separately through Retirement Planning Services, Inc. Insurance and annuity product guarantees are subject to the financial strength and claims-paying ability of the issuing insurance company. If you withdraw money from or surrender your contract within a certain time after investing, the insurance company may assess a surrender charge. Withdrawals may be subject to tax penalties and income taxes. Persons selling annuities and other insurance products receive compensation for these transactions. These commissions are separate and distinct from fees charged for advisory services. Insurance products also contain additional fees and expenses.
- Case studies are for illustrative purposes only and should not be construed as a testimonial. They only represent the experience of one advisory client. It is unknown if the client approved or disapproved of the adviser’s services. Each client’s situation is different, and their goals may not always be achieved.
- Content was prepared by artificial intelligence (AI). Retire Smart Maryland is a paid production of Elite Income Advisors, Inc.
