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By timestaff
May 30, 2014
Ann Cutting—Getty Images

An annuity is an insurance product that pays out income, and can be used as part of a retirement strategy.

Here’s how an annuity works: you make an investment in the annuity, and it then makes payments to you on a future date or series of dates. The income you receive from an annuity can be doled out monthly, quarterly, annually or even in a lump sum payment.

The size of your payments is determined by a variety of factors, including the length of your payment period.

You can opt to receive payments for the rest of your life, or for a set number of years. How much you receive depends on whether you opt for a guaranteed payout (fixed annuity) or a payout stream determined by the performance of your annuity’s underlying investments (variable annuity).

The biggest advantages annuities offer is that they allow you to sock away a larger amount of cash and defer paying taxes. But annuities have some significant drawbacks. For one, you must be willing to sock away the money for years. If you make a withdrawal within the first five to seven years and you typically will be hit with surrender charges of up to 7% of your investment or more. Annuities frequently charge other high fees as well, usually including an initial commission that can be up to 10% of your investment. If you purchase a variable annuity, ongoing investment management and other fees often amount to 2% to 3% a year.

These fee structures can be complex and unclear. Insurance agents and others who sell them may tout the positive features and downplay the drawbacks, so if you are considering an annuity, make sure that you ask a lot of questions and carefully review the fine print first.

You can learn more about annuities, and how to protect yourself, at the Securities and Exchange Commission Web site.

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The purpose of this disclosure is to explain how we make money without charging you for our content.

Our mission is to help people at any stage of life make smart financial decisions through research, reporting, reviews, recommendations, and tools.

Earning your trust is essential to our success, and we believe transparency is critical to creating that trust. To that end, you should know that many or all of the companies featured here are partners who advertise with us.

Our content is free because our partners pay us a referral fee if you click on links or call any of the phone numbers on our site. If you choose to interact with the content on our site, we will likely receive compensation. If you don't, we will not be compensated. Ultimately the choice is yours.

Opinions are our own and our editors and staff writers are instructed to maintain editorial integrity, but compensation along with in-depth research will determine where, how, and in what order they appear on the page.

To find out more about our editorial process and how we make money, click here.

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