Annuity pros and cons: what you gain, what you give up

The main advantages of an annuity are guaranteed income that can last for life, tax-deferred growth, and protection from market losses in fixed and fixed index contracts. The main disadvantages are reduced access to your money, surrender charges, fees that can be high on variable and rider-heavy contracts, and earnings that are taxed as ordinary income rather than at capital gains rates. Whether the trade is worth it depends on which of those you actually need.

Most pros-and-cons lists treat "annuity" as one product. It is not. A single premium immediate annuity, a multi-year guaranteed annuity, a fixed index annuity and a variable annuity with an income rider behave very differently, so a drawback that matters a lot for one type may barely apply to another. This guide works through each advantage and disadvantage, says which types it applies to, and finishes with the questions I would ask before signing anything.

The short version: annuity pros and cons at a glance

Advantages	Disadvantages
Income you cannot outlive (life-contingent payouts)	Money is tied up; surrender charges in early years
Tax-deferred growth on non-qualified money	Gains taxed as ordinary income, not capital gains
Principal protection on fixed and fixed index contracts	Fees on variable annuities and optional riders
No IRS annual contribution limit on non-qualified purchases	10% additional federal tax on most withdrawals before 59½
Optional death benefits and spousal continuation	Complexity makes contracts hard to compare
Predictable payments that help with budgeting	Fixed payments lose purchasing power to inflation
State guaranty association backstop, within limits	Protection depends on the insurer's claims-paying ability

The rest of this article explains each line, because the details decide whether a point is a real advantage for you or a sales talking point.

Advantage 1: income you cannot outlive

The feature that makes annuities unusual is longevity insurance. When you annuitize, or buy an immediate or deferred income annuity on a life-contingent basis, the insurer promises to keep paying for as long as you live. Nothing else in ordinary personal finance does this outside a traditional pension and Social Security.

The insurer can make that promise because it pools many contract holders. Those who die early effectively subsidise those who live long. That is also why the payout on a life annuity is higher than what you could safely withdraw yourself from the same sum: part of each payment is "mortality credit" that you only receive by giving up the right to leave the unused balance to heirs.

For someone whose main financial fear is running out of money in their nineties, this is the strongest argument for an annuity. If you want to see how a given premium might translate into income, our annuity payout calculator shows illustrative figures based on assumptions you set. Actual quotes vary by insurer, age and rates on the day, so verify before acting.

Advantage 2: tax deferral

Earnings inside a deferred annuity are not taxed until you withdraw them. For money that is already in an IRA or 401(k), this adds nothing, because the account is already tax-deferred. For non-qualified money (savings you have already paid tax on), deferral lets interest or investment gains compound without an annual tax drag.

There is also no IRS annual contribution limit on what you can put into a non-qualified annuity, unlike IRAs and workplace plans, which are capped at current annual IRS limits that change each year. That is why annuities are sometimes used by people who have already filled their tax-advantaged accounts.

The benefit is real but often overstated. It is worth most to someone in a high tax bracket now who expects a lower one later, and who will hold the contract long enough for deferral to outweigh the costs covered below. Our guide on how annuities are taxed explains the exclusion ratio, last-in-first-out ordering on withdrawals, and how qualified and non-qualified contracts differ.

Advantage 3: protection from market losses

Fixed annuities and multi-year guaranteed annuities credit a stated interest rate for a set period. Fixed index annuities credit interest linked to an index, subject to caps or participation rates, but with a floor (often zero) so the account value does not fall because of market declines. Both can suit money you cannot afford to see drop.

Variable annuities are different. Your money sits in subaccounts that rise and fall with the markets, and you can lose principal unless you pay for a rider that guarantees a minimum benefit. Registered index-linked annuities sit in between, with a buffer or floor that limits but does not eliminate losses.

So "principal protection" is a genuine advantage for some annuity types and not a feature of annuities in general. Our comparison of fixed vs variable annuities sets out where each type sits.

Advantage 4: death benefits, spousal options and predictability

Most deferred annuities pay at least the account value to named beneficiaries on death, and they pass outside probate when the beneficiary designation is in order. Joint-life payouts and spousal continuation let a surviving spouse keep the income or the contract going.

Fixed payments also make budgeting simpler. Knowing that a set amount will arrive each month alongside Social Security can make it easier to plan spending and to take risk elsewhere in a portfolio.

Disadvantage 1: your money is tied up

Deferred annuities usually carry a surrender charge schedule. If you withdraw more than the free withdrawal allowance (commonly a percentage of the account value each year) during the surrender period, the insurer deducts a charge. The charge typically declines year by year and disappears at the end of the schedule, but the period can run for many years. Some contracts also apply a market value adjustment that can raise or lower what you receive if you surrender early.

With an immediate annuity or an annuitized contract, liquidity is usually gone entirely. You exchanged a lump sum for a stream of payments, and in most life-only contracts there is no cash value to take back.

This is the drawback I see cause the most regret. An annuity should be funded with money you will not need for emergencies, and only after you have checked the surrender schedule in the contract itself. Our guide to annuity fees and surrender charges explains how to read the schedule.

Disadvantage 2: fees and costs

Costs vary enormously by type:

• Fixed annuities and MYGAs usually have no explicit annual fee. The insurer's cost and profit are built into the rate it credits, which is why comparing rates across insurers matters.
• Fixed index annuities typically have no base annual fee, but optional income or enhanced death benefit riders carry their own annual charges, and caps and participation rates limit the upside.
• Variable annuities usually charge a mortality and expense risk fee, administrative fees and underlying fund expenses, plus any rider charges. Stacked together, these can take a meaningful share of annual returns.

Commissions are generally built into the contract rather than charged to you separately, but they influence surrender schedules and product design. Ask for every fee in writing, as a percentage and as a dollar amount on your premium.

Disadvantage 3: tax treatment of gains

Annuity earnings are taxed as ordinary income when withdrawn, not at the lower long-term capital gains rates that apply to many taxable investments. If you hold equity-like investments inside a variable annuity, you can convert what would have been capital gains into ordinary income.

Non-qualified annuities also do not receive a step-up in basis at death. Beneficiaries pay ordinary income tax on the gain above what the owner paid in, whereas many inherited taxable investments get a basis step-up. For estate planning, that difference can outweigh years of deferral.

Withdrawals of earnings before age 59½ are generally subject to a 10% additional federal tax on top of income tax, unless an IRS exception applies. Our article on annuity withdrawal rules covers the exceptions.

Disadvantage 4: inflation and opportunity cost

A level payment buys less every year that prices rise. Over a long retirement the loss of purchasing power can be large. Some insurers offer inflation-linked or step-up payout options, but they start with a lower initial payment, and availability varies.

There is also opportunity cost. Money in a fixed annuity is not invested in assets that may grow faster over long periods, and caps on index annuities limit participation in strong market years. That is the price of the guarantees, and it is reasonable to pay it only for the part of your savings that needs guarantees.

Disadvantage 5: the guarantee is only as good as the insurer

Annuity guarantees are backed by the issuing insurance company, not by the FDIC. State guaranty associations provide a backstop if an insurer fails, but coverage limits vary by state and are not a substitute for choosing a financially strong insurer. Check the insurer's ratings and your own state guaranty association's limits before buying, and be careful with amounts above those limits.

Who annuities tend to suit, and who they don't

Annuities can make sense when:

• you want a floor of guaranteed income on top of Social Security and any pension
• you are worried about outliving savings and are in reasonable health
• you have already used up tax-advantaged accounts and want deferral on additional savings
• you want principal protection for a defined portion of savings and accept limited upside

They tend to be a poor fit when:

• you may need the money within the surrender period
• you have no emergency fund
• you are buying inside an IRA or 401(k) purely for tax deferral you already have
• you want to leave appreciated assets to heirs with a basis step-up
• you do not understand how the contract credits interest or charges fees

Questions to ask before you buy

1. What type of annuity is this, and which guarantees are in the base contract versus paid riders?
2. What is the full surrender schedule, the free withdrawal allowance, and is there a market value adjustment?
3. What are all the annual fees, in percentage and dollar terms?
4. How are crediting rates, caps or participation rates set after the initial period?
5. What are the insurer's financial strength ratings, and what does my state guaranty association cover?
6. How will withdrawals, income and death benefits be taxed in my situation?
7. What is the free-look period, and how do I cancel within it?

FINRA and the SEC publish investor alerts on variable and indexed products, and your state insurance department can confirm whether an agent is licensed and whether complaints have been filed.

Frequently asked questions

What is the biggest disadvantage of an annuity?

For most buyers it is lost liquidity. Surrender charges on deferred annuities, and the near-total loss of access on immediate or annuitized contracts, mean the money is not available for emergencies. Fees on variable and rider-heavy contracts are a close second.

Are annuities a good idea for retirees?

They can be for the portion of savings meant to provide guaranteed income, especially for people concerned about longevity. They are rarely a good home for all of someone's savings, and whether one suits you depends on your other income, health, tax position and need for access.

Do annuities lose money?

Fixed annuities and MYGAs do not lose value from market declines, and fixed index annuities usually have a zero floor, although surrender charges can reduce what you get back if you exit early. Variable annuities can lose value because they are invested in market subaccounts.

Are annuity earnings taxed?

Yes. Earnings are taxed as ordinary income when withdrawn, and earnings withdrawn before 59½ are generally also subject to a 10% additional federal tax unless an exception applies. Non-qualified contracts tax only the gain; qualified contracts held in IRAs or workplace plans are generally fully taxable on withdrawal.

This article is general education, not personal financial advice. Rates, fees and contract terms change, so read the contract and illustration, and consider a fee-only adviser or tax professional before acting.