How Annuities Work, Step by Step

Every annuity follows the same path. You apply through a state-licensed agent, the insurer approves the contract, and you fund it with a premium: a single lump sum, or a series of payments for a flexible-premium contract. The insurer issues the contract, and the free-look period begins, usually 10 to 30 days depending on your state, during which you can cancel for a full refund.

From that point the contract has an account value that the insurer reports on periodic statements. Interest or investment results are credited to it on the schedule the contract describes: daily, monthly, or at the end of each index term. Charges, if the contract has any, are deducted on the same statements so you can see both sides.

Money leaves the contract in three ways. You can take withdrawals during the accumulation phase. You can start income, either by annuitizing or by turning on an income rider. Or the contract pays a death benefit to your beneficiary. The contract sets rules for each, and the rules are where most of the surprises live, so they are worth reading before the free-look period ends.

Takeaway: Premium in, growth credited, money out by withdrawal, income, or death benefit: every annuity is those three steps with different rules attached.

The type of annuity decides how the account value grows, and that single difference drives almost everything else about the contract.

• Fixed and multi year guaranteed annuities (MYGAs): the insurer declares an interest rate and credits it, usually daily, compounding inside the contract. A MYGA locks the rate for the full term; a traditional fixed annuity guarantees it for a year at a time with a contractual minimum after that.
• Fixed index annuities (FIAs): interest is calculated at the end of each term, commonly one year, from the change in an index such as the S&P 500. The insurer applies a cap (a maximum credited percentage), a participation rate (the share of the index gain you receive), or a spread (a percentage subtracted from the gain). If the index falls, the credited interest is 0%, never negative, so the account value does not drop from market losses.
• Registered index-linked annuities (RILAs): also index-linked, but a buffer or floor means you absorb some losses in exchange for higher caps. Because the value can fall, RILAs are securities.
• Variable annuities: the premium is allocated among sub-accounts that work like mutual funds. The account value moves with those investments every business day, up or down, and fees are deducted along the way.

Takeaway: A 0% floor means a bad index year credits nothing, not that the contract loses nothing: fees and surrender charges still apply if you withdraw.

There are two different ways an annuity produces guaranteed income, and buyers often confuse them because both are described as "lifetime income".

Annuitization converts the account value into a schedule of payments. The insurer uses your age, the payout option you choose (life only, life with a guaranteed period, joint and survivor, or period certain), and its current payout rates to set a fixed dollar amount. The amount is usually the highest available for the money, because you give up the lump sum: after annuitization there is no account value to withdraw, and, on a life-only option, nothing passes to heirs.

A guaranteed lifetime withdrawal benefit (GLWB) rider, available on many FIAs and variable annuities for an annual fee, guarantees a withdrawal you can take every year for life even if the account value runs out. The amount is a withdrawal percentage, which rises with the age at which you start, multiplied by a benefit base. The benefit base is a separate bookkeeping number: it often grows by a guaranteed roll-up rate during deferral and is not money you can withdraw as a lump sum. Your real account value continues to exist and passes to beneficiaries, minus what you have taken.

The difference in practice: annuitization usually pays more per dollar; the rider keeps your account value and death benefit. A specialist can show both figures for the same premium side by side, which is the only fair way to compare them.

Takeaway: Benefit base is not cash. It is the number the rider multiplies to set your guaranteed withdrawal; the account value is what you actually own.

During the accumulation phase, most deferred annuities let you withdraw a set amount each contract year without a charge, commonly 10% of the account value, sometimes accumulated interest only in the first year. Withdrawals above that amount during the surrender period incur a surrender charge, a percentage of the excess that declines each year until it reaches zero. MYGAs often set the free amount lower or waive it in exchange for the higher locked rate.

Many contracts also apply a market value adjustment (MVA) to early withdrawals from fixed and MYGA contracts: if interest rates have risen since you bought, the adjustment reduces what you receive; if rates have fallen, it can increase it. Common waivers let you withdraw without charge for nursing home confinement, terminal illness, or required minimum distributions from a qualified contract.

The table below shows the shape of a typical schedule. The percentages are illustrative only; your contract states its own.

Takeaway: The surrender schedule is the real cost of a fixed or index annuity. Match the term to money you will not need before it ends.

If the owner dies during the accumulation phase, the contract pays a death benefit to the named beneficiary, usually the account value or the premiums paid minus withdrawals, whichever is greater, and generally without surrender charges. Because there is a named beneficiary, the money passes outside probate.

If death happens after annuitization, what the beneficiary receives depends on the payout option. Life only pays nothing further. Life with a period certain pays the remaining guaranteed payments. Joint and survivor continues to the surviving spouse. Federal tax law requires most non-spouse beneficiaries of a deferred annuity to take the money within a set period, while a surviving spouse can usually continue the contract as the new owner.

Earnings in the death benefit are taxable to the beneficiary as ordinary income; unlike stocks, an annuity gets no step-up in basis at death. That rule shapes how many people decide whether an annuity or a taxable account should be the asset they plan to leave behind.

Growth inside a deferred annuity is not taxed year to year. Withdrawals from a non-qualified annuity are treated as earnings first (last in, first out) and taxed as ordinary income until all gain has been taken, then as tax-free return of premium. Annuitized payments are split between taxable earnings and excluded premium using the IRS exclusion ratio.

Taxable amounts taken before age 59 and a half generally owe a 10% additional federal tax, with exceptions for death, disability, and substantially equal periodic payments. If the annuity sits inside an IRA or 401(k), the account's own rules govern instead, and required minimum distributions apply.

Imagine a 62-year-old who moves part of her savings into a 7-year fixed index annuity with a lifetime income rider, planning to start income at 70. For seven years the account value is credited each anniversary with whatever the index formula produces, never less than zero, while the rider deducts its annual fee. Her statements show the account value and, separately, the benefit base growing at the rider's guaranteed roll-up.

At 65 she needs a new roof and takes a withdrawal inside the free 10% amount: no surrender charge, but the earnings portion is taxable, and because she is over 59 and a half there is no penalty. At 70 she turns on the rider. The insurer multiplies the benefit base by the withdrawal percentage for a 70-year-old and pays that amount every year for as long as she lives, even if her account value is eventually exhausted. Whatever account value remains at her death goes to her named beneficiary.

Had she annuitized at 70 instead, the yearly payment would likely have been higher, but the remaining account value and the death benefit would have been gone. That is the choice the rider exists to offer.

Takeaway: Every number in that example comes from a page in the contract: crediting method, fee, free withdrawal, rider withdrawal percentage, death benefit. Ask to see each one.