Annuities Explained by a Fee-Only Planner: Types, Costs, and Taxes

What an Annuity Actually Is

At its core, an annuity moves a risk from you to an insurer. The oldest version is the simplest: give an insurer a lump sum, and it pays you income for as long as you live. The insurer can promise that because it pools many buyers. Some will die early and some will live long, and the money left behind by those who die early helps fund those who live longest. Those transfers, called mortality credits, are the one thing an annuity can do that no portfolio can: they let a pooled buyer spend more each year than an individual could safely spend from the same savings, without the risk of running out.

Most annuities sold today do something else. They are built for accumulation: money goes in, grows tax-deferred, and may or may not ever be turned into lifetime income. Many carry optional riders that promise a minimum income later, layered on top of the accumulation contract. Keeping the two jobs separate, income versus accumulation, is the first step in evaluating any contract, because the costs, risks, and tax treatment follow from which job it is doing.

Every annuity guarantee rests on the insurer’s ability to pay. (A variable annuity’s subaccounts are held apart from the insurer’s general account; its guarantees are not. A registered index-linked annuity’s value, like a fixed annuity’s, is itself a promise from the insurer.) Fixed, fixed indexed, and income annuities, and the guarantees on variable ones, are backed by the insurer’s general account, a portfolio of bonds, mortgages, and other credit investments, so how the insurer invests, and who reinsures its obligations, is part of what the guarantee rests on. Behind the insurer, each state has a guaranty association that steps in if an insurer fails, with coverage limits described below.

The Five Main Types of Annuities

Immediate income annuities. A lump sum buys payments that start within a year, for life, for a set period, or for the longer of the two. These are the purest form of longevity insurance. The trade is liquidity: once payments begin, the lump sum is generally gone, and a contract without an inflation adjustment pays the same dollars in year 25 as in year one. Features that protect heirs if the buyer dies early, such as a cash refund or a guaranteed payment period, are paid for with lower income, because they shrink the mortality credits that make the contract efficient.

Deferred income annuities. The same idea with a waiting period: buy now, and payments begin at a later age, such as 80 or 85. Because the insurer holds the money longer and some buyers will not live to collect, each dollar of premium buys considerably more income than an immediate annuity would. A version bought inside a retirement account, the qualified longevity annuity contract, can be funded with up to $210,000 per person in 2026 (a lifetime limit across all such contracts) and is excluded from required minimum distribution calculations until payments begin; our article on QLACs covers that version in depth.

Fixed annuities. The best-known form, the multi-year guaranteed annuity, pays a declared interest rate for a set term, much like a certificate of deposit issued by an insurer instead of a bank. Interest grows tax-deferred. Withdrawing more than a contract’s penalty-free amount before the term ends usually triggers a surrender charge, and some contracts add a market value adjustment that raises or lowers the payout depending on how interest rates have moved.

Fixed indexed annuities. These credit interest based on a market index, with a floor that keeps the credited rate from going below zero (rider charges, if any, can still reduce the value in a year with no credit). The money is not invested in the index. The insurer limits the upside through a cap (a maximum credited rate), a participation rate (a share of the index’s gain), or a spread (a deduction from the gain), and it can generally reset those terms periodically. Index returns used for crediting usually exclude dividends. These contracts are regulated as insurance rather than securities, often carry long surrender schedules, and are frequently sold with income riders. Every contract states minimum guaranteed terms separately from its current ones, and the gap between the terms offered at purchase and the terms credited at renewal is one of the most important things to check before buying.

Variable and registered index-linked annuities. A variable annuity invests in subaccounts that work like mutual funds, so the value rises and falls with the markets, and it is regulated as a security, sold with a prospectus. Charges are layered: a mortality and expense charge, administrative fees, the underlying fund expenses, and the cost of any riders that guarantee a death benefit or a minimum income. A registered index-linked annuity sits between fixed indexed and variable: it ties returns to an index with a cap, but instead of a zero floor it offers a buffer (the insurer absorbs the first slice of losses) or a floor (the most the buyer can lose), in exchange for a higher cap.

What Annuities Cost: Fees, Spreads, and Surrender Charges

Annuity costs come in two forms, and the second is easier to miss.

Explicit charges. Variable and registered index-linked annuities state their fees: mortality and expense charges, administrative fees, fund expenses, and rider charges, each expressed as an annual percentage. Riders that guarantee a minimum lifetime income usually charge against a “benefit base,” a notional number that can grow at a stated roll-up rate. The benefit base is not cash: it is used only to calculate guaranteed withdrawals, and it cannot be taken as a lump sum. Mistaking a benefit base’s roll-up rate for an investment return is one of the most common misunderstandings about these riders.

Implicit costs. Fixed and fixed indexed annuities usually show no annual fee, but they are not free. The insurer earns its margin by crediting less than it earns on the money, which is built into the declared rate or the cap, participation rate, or spread. Comparing those terms across contracts, and against what the same money would earn elsewhere, is the only way to see the cost.

Surrender charges. Most deferred annuities charge a declining percentage for withdrawals above a penalty-free amount during the first several years. Surrender schedules exist partly because many contracts pay a commission to the selling agent up front, and the insurer recovers that cost over time; a buyer who leaves early pays it back through the charge.

How the seller is paid. Annuities sold through insurance agents and brokers typically pay a commission from the insurer, which is built into the contract’s economics. Versions designed for fee-only advisors pay no commission, often carry shorter surrender schedules or none, and leave the advisor’s fee as a separate, visible cost. Neither structure makes a contract right or wrong, but knowing which one you are looking at tells you where the cost sits. A fee-only planner receives nothing from the insurer either way. A planner paid a percentage of assets has a pull of its own, toward keeping money in the managed portfolio, which is one more reason the comparison should be run on the numbers.

How Annuities Are Taxed

The tax rules below apply to nonqualified annuities, bought with money outside a retirement account and owned by an individual. A contract held by a corporation or other entity that is not acting as an agent for an individual generally loses the deferral entirely.

Deferral, then ordinary income. Earnings inside the contract are not taxed until they come out. When they do, they are ordinary income, not capital gains, no matter whether the growth came from interest, dividends, or stock market gains in a variable subaccount. Deferral converts what might have been long-term capital gains into income taxed at ordinary rates. Texas has no personal income tax, so for Texas residents the comparison is federal only; households in, or moving between, other states should add state income tax to it.

Gains come out first. For contracts bought after August 13, 1982, withdrawals before annuitization are treated as coming from earnings first. Until all of the gain has been withdrawn, every dollar taken out is taxable. Multiple deferred annuities bought from the same insurer in the same calendar year are treated as a single contract for this purpose, so splitting a purchase does not change the result.

The 10% additional tax. Taxable withdrawals before age 59½ generally owe an extra 10%, with exceptions that include death, disability, payments that are part of a series of substantially equal periodic payments, and payments from an immediate annuity.

Annuitized payments. Once a contract is converted to a stream of payments, each payment is split into a tax-free return of the money put in and taxable earnings, using an exclusion ratio: the investment in the contract divided by the expected total of the payments (for lifetime payments, projected using IRS life expectancy tables). After the full investment has been recovered, the remaining payments are fully taxable; if payments end at death before it has been recovered, the unrecovered amount can generally be deducted on the final return.

The net investment income tax. Taxable income from a nonqualified annuity counts as net investment income, so it can owe the 3.8% surtax above the $250,000 (married filing jointly) and $200,000 (single) thresholds. Distributions from annuities inside retirement accounts do not, though they still count toward the income that the thresholds are measured against.

No step-up at death. The untaxed gain in a deferred annuity is income in respect of a decedent. Heirs owe ordinary income tax on it, generally within five years of the death or through payments that begin within a year and stretch over the beneficiary’s life expectancy; a surviving spouse can usually continue the contract instead. For a nonqualified annuity, it is generally the death of any owner that starts the required payout, so a jointly owned contract can be forced to pay out at the first owner’s death; a surviving spouse’s right to continue the contract comes from being named the beneficiary, not from joint ownership. Stocks or funds held in a taxable account would instead get a new basis at death; the step-up in basis rules explain why that difference matters more for many families than the deferral did.

Exchanges. Section 1035 lets an owner exchange one annuity for another, an annuity for a qualified long-term care insurance policy, or a life insurance policy that is no longer needed for an annuity, without tax, provided the money moves directly from one contract to the other. An exchange carries the old contract’s basis and gain into the new one, usually starts a new surrender schedule, and leaves behind the old contract’s riders and any guaranteed death benefit (after a partial exchange, the guarantees on the remaining contract are usually reduced). Part of an annuity can also be moved into a new annuity, and the IRS treats the split as tax-free as long as nothing is taken out of either contract for 180 days afterward, other than payments for life or for at least 10 years; a withdrawal inside that window lets the IRS treat the transaction according to its substance, which can make part of it taxable.

Inside an IRA. An annuity held in an IRA or 401(k) adds no tax deferral, because the account is already tax-deferred, and its withdrawals follow the retirement account’s rules rather than the annuity rules above. Whatever it costs has to be justified entirely by the guarantees it provides.

A Worked Example: Taxes on a $500,000 Annuity

Consider a married couple, both 63 and not yet collecting Social Security, who bought a nonqualified deferred annuity for $300,000 that is now worth $500,000, a $200,000 gain. Their other income already puts them in the 22% federal bracket, and even with the withdrawals below, their taxable income stays within it and their modified adjusted gross income stays below the $250,000 threshold for the net investment income tax.

A $50,000 withdrawal. Because gains come out first, the entire $50,000 is ordinary income, and at 22% it costs $11,000 of federal tax. If the same $500,000 sat in a taxable brokerage account with the same $300,000 basis (setting aside the tax it would have paid on dividends along the way), selling $50,000 of it would realize a gain of $20,000, the 40% of each dollar that is growth, taxed at the 15% long-term rate: $3,000. The same withdrawal from the same gain costs more than three and a half times as much from the annuity.

Annuitizing instead. Suppose they convert the contract into payments of $40,000 a year for 20 years. For a fixed-period payout, the expected return is simply the total of the payments, $800,000, so the exclusion ratio is $300,000 divided by $800,000, or 37.5%: $15,000 of each payment is a tax-free return of their investment and $25,000 is ordinary income, $5,500 of federal tax a year at 22%. A lifetime payout works the same way, except that the expected return comes from IRS life expectancy tables, and once the full $300,000 has been recovered, every later payment is fully taxable. Annuitizing spreads the gain over many years, but it never turns it into a capital gain.

At death. If they never withdraw or annuitize, their children inherit a contract with $200,000 of untaxed gain and owe ordinary income tax on it at their own rates. The same growth in a taxable account would have received a step-up in basis, leaving nothing to tax.

Before 59½. Had the owner been 55 instead of 63, the $50,000 withdrawal would also owe the 10% additional tax, another $5,000.

Texas: Creditor Protection and Guaranty Coverage

Texas is unusually protective of annuities. Under the Texas Insurance Code, annuity benefits, including a contract’s cash value, are fully exempt from garnishment, seizure, creditors’ claims, and demands in bankruptcy. There are three exceptions: premiums paid in fraud of a creditor, debts secured by a pledge of the contract, and child support liens. State exemptions also do not stop a federal tax levy, and in bankruptcy a household that moved to Texas within roughly the last two years may be held to its former state’s exemptions. Other states range from similar protection to very little, which matters for a household that may move or that already has family and property in more than one state.

Each state’s life and health insurance guaranty association covers annuities if an insurer fails, up to limits that are measured on the present value of the contract’s benefits, not on the premium paid. In Texas, as in most states, the limit is $250,000 per person per insurer, with exclusions. The guaranty association is a backstop; the first line of protection is the insurer itself.

When an Annuity Earns Its Place

The case for an annuity is strongest when it solves a specific problem that the rest of the plan cannot solve as well.

Longevity. For a retiree whose guaranteed income does not cover essential spending, and who would otherwise underspend for fear of running out, lifetime income can be worth more than its expected return suggests. People spend guaranteed income far more readily than they spend savings. Before buying it from an insurer, though, it is worth remembering that Social Security is the one guaranteed lifetime income most retirees already have that adjusts for inflation, and it can be made larger by delaying the claim, a decision best settled on actual numbers; our article on when to claim Social Security covers it. A pension that offers a choice between monthly income and a lump sum raises the same question from the other direction, and our article on comparing a pension lump sum with its annuity walks through it.

The right comparison. An income annuity is best judged against the safe assets it would replace, not against stocks. Compared with a bond ladder, it can pay more for a buyer who lives a long time, because mortality credits add to the interest; compared with a stock portfolio held for decades, it will usually pay less. That is why lifetime income, when it fits, tends to come out of the bond side of a plan. A fixed payout also carries a long-term bond’s risks: a rate locked in for decades, no protection from inflation, and dependence on one issuer’s credit. The mortality credits raise the payout; they do not remove any of those risks.

What the research adds. Two findings temper the case for buying lifetime income early. Economists Felix Reichling and Kent Smetters, in a 2015 American Economic Review paper, showed that a serious health event can shorten life expectancy, lowering the value of lifetime income, at the same moment it raises costs; in their model, that combination left most households better off holding no annuities at all. One practical implication is keeping a separate reserve for health and long-term care alongside any annuity. And research by Michael Kitces and Wade Pfau found that much of the benefit earlier studies credited to partial annuitization came from the order in which assets were spent (drawing on the safe assets first, which leaves the remaining portfolio more stock-heavy over time) rather than from the annuity itself; the annuity’s own edge, its mortality credits, showed up mainly for those who lived well past life expectancy. Both findings are consistent with income that starts later in life, such as a deferred income annuity, when longevity is the worry.

Inflation. A fixed nominal payment loses purchasing power every year. Contracts with built-in annual increases exist, and a small number have tied payments directly to inflation, but all of them start with a smaller payment, and any fixed annuity’s value has to be judged in real terms, not just in dollars. At 3% inflation, a fixed payment loses about 45% of its purchasing power over 20 years.

Safety with a known rate. For a conservative saver, a fixed multi-year annuity can be a reasonable alternative to certificates of deposit or bonds, with tax-deferred interest, as long as the money will not be needed before the surrender period ends, or, for a saver younger than 59½, before that age, when interest withdrawn would generally also owe the 10% additional tax.

Where it usually does not fit. Buying a deferred annuity mainly for tax deferral on investments that would otherwise earn long-term capital gains trades lower capital gains rates and a step-up at death for ordinary income later. Buying one inside an IRA for deferral adds nothing. And any contract with a long surrender schedule is a poor home for money that may be needed in the meantime.

Reviewing an Existing Annuity: Keep, Exchange, or Surrender

Many people come to the annuity question already owning one. Whether to keep it, exchange it, annuitize it, or surrender it usually comes down to six questions.

What it costs. For a variable or index-linked contract, that means totaling the contract charges, rider fees, and fund expenses. For a fixed or fixed indexed contract, it means comparing the current rate or cap with what similar money earns elsewhere, and with the contract’s guaranteed minimums.

What the money could do instead. The opportunity cost is the gap between the contract’s likely result after its costs and the best realistic alternative, both measured after tax. Surrendering a contract with a large gain makes all of that gain ordinary income in a single year; keeping it continues the deferral but leaves the heirs ordinary income with no step-up.

Where it sits in the surrender schedule. The cost of leaving usually falls each year. A charge that disappears in a few months changes the math, and a penalty-free withdrawal allowance can move money out gradually, though each withdrawal is still taxed gains first.

Whether a rider is worth keeping. A guarantee is worth roughly what it would cost to replace. If market losses have left a guaranteed benefit base well above the cash value, the rider may be worth more than its fee; if the guaranteed income is less than the cash value could buy in a new immediate annuity, the fee may be buying little.

Which exchange options exist. A lower-cost contract, an immediate annuity, or a qualified long-term care policy can each be reached tax-free through a full or partial 1035 exchange, with the trade-offs described above: usually a new surrender schedule, and the loss or reduction of the old contract’s riders and death benefit.

What holding it risks. The insurer’s ability to pay, with guaranty coverage capped; renewal terms that can reset lower; inflation on fixed payments; money tied up while needs change; an ownership and beneficiary setup that can force an early payout; and, for the heirs, ordinary income tax on the gain.

How We Think About It

We lean toward treating an annuity as insurance bought for a named risk, sized to the gap that remains after the rest of the plan. That means settling the Social Security claiming decision first, on actual numbers rather than a delay-by-default rule; sizing any Roth conversions for the years before required distributions second; and then considering an insurance contract for whatever longevity worry remains, with inflation risk on fixed payments weighted honestly. It is the same sequence our QLAC article lays out. For many households, that sequence leaves little for an annuity to do; for some, it leaves exactly the risk an annuity is built to cover. When one does fit as longevity insurance, we lean toward the plainest form, an income annuity, immediate or deferred, whose single job is clear, over contracts that blend an investment with a guarantee.

We lean toward judging any annuity bought for accumulation against the same money invested in an ordinary taxable account, after every cost and after tax: the conversion of capital gains into ordinary income, the gains-first withdrawal rule, and the step-up that the annuity gives up at death. Deferral alone rarely justifies one. The narrow exception is a very low-cost contract, held for many years by an investor in a top bracket as a wrapper for tax-inefficient investments, and even then the gains come out as ordinary income and the heirs give up the step-up. A fee-only planner receives nothing from the insurer either way, so the comparison can be run on the numbers, with any pull an asset-based fee creates named openly.

For a contract someone already owns, we lean toward a fresh assessment on every front rather than an appeal to what has already been paid in. Premiums, fees, and years already spent are gone under every option; a surrender charge still ahead is not, because it is a real cost of leaving, and the tax basis those premiums created still sets the tax on each choice. The question is which choice is best from here: what the contract costs, what the money could do elsewhere after tax, where it sits in its surrender schedule, whether any rider is worth its cost, which exchange options exist, and what holding it risks. Keeping, exchanging, annuitizing, and surrendering can each be the right answer.

Common Questions

How are withdrawals from an annuity taxed?

For a nonqualified annuity bought after August 13, 1982, withdrawals before annuitization come from earnings first, and those earnings are taxed as ordinary income, not capital gains. Taxable withdrawals before age 59½ generally owe an additional 10% tax, with exceptions. Once a contract is annuitized, each payment is split between a tax-free return of the original investment and taxable earnings, using an exclusion ratio.

Do annuities get a step-up in basis at death?

No. The untaxed gain in an annuity is income in respect of a decedent, so the heirs owe ordinary income tax on it, generally within five years or through payments over their life expectancy that begin within a year of the death. A surviving spouse can usually continue the contract. Stocks or funds held in a taxable account would instead receive a step-up in basis.

Are annuities protected from creditors in Texas?

Generally, yes. The Texas Insurance Code fully exempts annuity benefits, including cash value, from garnishment, seizure, creditors’ claims, and bankruptcy, with exceptions for premiums paid in fraud of creditors, debts secured by a pledge of the contract, and child support liens. Protection in other states varies widely.

Should I keep, exchange, or surrender an annuity I already own?

It depends on what the contract costs, what the money could do elsewhere after tax, where it sits in its surrender schedule, whether any rider is worth keeping, which exchange options exist, and what holding it risks. A surrender makes the entire gain ordinary income at once; a 1035 exchange moves the basis and gain to a new contract without tax, but usually starts a new surrender schedule and gives up the old contract’s riders and any guaranteed death benefit.