What Is an Income Annuity?

An income annuity is one way people try to turn a lump sum into a paycheck they cannot outlive, or into payments for a stated period. That idea is simple to say and easy to oversimplify. You are usually trading liquidity — the ability to take the money back as a lump sum — for a contractual stream of payments. Whether that trade is a fit depends on your other income, your need for cash, and the exact contract, not on a generic slogan about “guaranteed income.”

The National Association of Insurance Commissioners (NAIC) publishes consumer material on annuities, including the difference between accumulating money in a deferred annuity and taking payments under a payout option. This article focuses on income annuities. For a comparison with bank CDs, see annuity versus CD. For other annuity types, see annuities and fixed versus fixed indexed annuities.

Annuities are insurance contracts, not bank deposits, and they are not FDIC-insured. They are offered only through brokers with the required license and appointment. Features, payments, and surrender terms vary. This is not tax, legal, or investment advice.

How an income annuity is designed to work

You pay a premium, either as a lump sum or, in some designs, as a series of premiums. In return, the insurer agrees to pay you (and, if you elect it, a joint annuitant) a stream of payments. A single premium immediate annuity, often abbreviated SPIA, typically starts payments within a year. A deferred income annuity starts at a later date you choose, sometimes years after the premium is paid.

Payment options commonly include life only; life with a period certain, so payments continue to a beneficiary if you die early in the period; and joint life, which can continue while either of two people is alive. A life-only option usually pays more per period than an option with a longer guarantee to heirs, because the insurer’s obligation may end at death. The contract, not a brochure, controls the amount and the conditions.

Once payments are set up, you typically cannot undo the contract the way you might cash a CD or spend a brokerage account. Some contracts have limited commutation or withdrawal features; many do not. That loss of liquidity is the central tradeoff.

What an income annuity is not

It is not a life insurance death benefit, although some options leave a remainder for a beneficiary. It is not a certificate of deposit. A CD is a bank deposit, usually FDIC-insured within limits, with a stated term and an early-withdrawal penalty. An income annuity is a claim on the insurer, backed by that company’s ability to pay, and sometimes by a state guaranty association up to statutory limits — which are not the same as FDIC insurance and should not be treated as a selling point without reading the actual limits.

It is also not the same as a deferred annuity you are still accumulating in, where surrender charges may apply if you withdraw early. Some people buy a deferred annuity first and later “annuitize” it, converting the account to a payment stream. That election is usually irreversible. See annuity surrender charges explained if you are still in the accumulation period, and qualified versus non-qualified annuities for the tax setting of the money you would use.

Questions that actually help you decide

• What income do I already have that I cannot outlive, such as Social Security, and what gap am I trying to fill?
• How much of my savings can I afford to make illiquid?
• Do I need a payment that lasts only my life, or also a spouse’s life, or a period certain for heirs?
• What fees, payment amount, and inflation treatment — if any — are in the contract, and what is guaranteed versus illustrated?
• What happens if I die early, and who is the beneficiary under the option I chose?

Inflation can reduce the purchasing power of a fixed payment over a long retirement. Some contracts offer increasing payments or other features, usually in exchange for a lower starting amount. Do not assume a payment will keep up with prices unless the contract says so.

Because this is a long-term promise from an insurer, financial strength and the exact contract language belong in the review. A licensed insurance broker can help you compare options. A tax professional should review how payments would be taxed in your situation, especially if the premium comes from a retirement account.

How it can sit next to Social Security and other savings

Social Security already provides a lifetime income stream, with its own rules about claiming age and survivor benefits. An income annuity is sometimes used to fill a gap above that floor — for example, to cover a portion of essential monthly costs if a pension is small or absent. It does not replace a review of whether you also want life insurance in retirement, or whether a surviving spouse would have enough income if one person dies first. See should I keep life insurance in retirement and Social Security survivor benefits and life insurance.

Because the contract is usually long, it can help to decide the payment start date and the joint-life option with a spouse in the room, not as a last-minute election. Once payments begin under many options, the choice is difficult or impossible to reverse.

The bottom line

An income annuity can create a contractual payment stream, often for life, in exchange for a premium and for much of your access to the principal. It can be a fit for a portion of savings when longevity risk is the concern, and a poor fit if you need liquidity or if too much of your net worth would be locked in. Read the payment option and the guarantees carefully, and compare it with the income you already have before you apply.

Sources: NAIC, Annuities · SEC Investor.gov, Annuities · FDIC, Deposit Insurance

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This article is general and educational, not an offer to sell insurance or financial, tax, or legal advice. Coverage, benefits, and availability vary by carrier, product, and state, and all coverage is subject to underwriting.