Understanding the Basics of Annuities 

How Do Annuities Work?

What is an Annuity?

An annuity is an insurance contract designed to provide a steady stream of income after retirement. There are various types of annuities. The main types include fixed, variable, immediate, and deferred annuities. Each annuity offers certain features that may enable you to achieve your financial goals for retirement. 

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How Do Annuities Work?

To address “How do annuities work?”, let’s focus on fixed index annuities. A fixed index annuity (FIA) is a way of saving for retirement as well as providing a guaranteed income after retirement. FIAs offer retirees the chance to earn indexed interest without the risk of losing money in the market. Additionally, FIAs have a higher interest growth potential and a lower risk than variable annuities.


Fixed index annuities are based on index performance, such as the S&P 500.  So, they provide some of the same benefits as index funds but aren’t directly linked to an index. The reason is that an FIA is an insurance policy and not an investment. As a result, fixed index annuities are generally protected against principal declines even if the market declines. 

Phases of Annuities

Annuity contracts have two stages. These two phases are the same for all types of annuities, even though they differ in detail. They are accumulation and distribution. So, what happens in each phase? 

Phase 1: Accumulation

You accumulate value by letting your retirement money grow.  An index annuity will grow with a set interest rate regardless of market conditions.  Also, FIAs may result in higher returns when the index rises while protecting your principal when the index declines. Your money will continue to grow over time.

Phase 2: Distribution

During the distribution phase, you begin receiving regular income payments from your annuity.  Payments can be scheduled for monthly, quarterly, or annual intervals. There is also the option of receiving a lifetime income. Certain annuity payments may be withdrawn without penalty.

Annuities and Taxes

As your money accumulates, it grows tax-free*. You only pay taxes when you withdraw your money. Therefore, this can be very helpful if you want to lower your tax liability.

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