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An annuity is a contract between you and an insurance company. You hand over a lump sum (or a series of premiums) and the insurer promises to pay you income later — either over a fixed period or for the rest of your life. That's it. The structure looks like life insurance in reverse: instead of protecting against dying too soon, an annuity protects against living too long and running out of money.

Annuities come in two broad flavors. Immediate annuities start paying within 30 days of purchase. Deferred annuities grow tax-deferred for years or decades before converting into income. Most retirees hold deferred annuities while they build a nest egg, then annuitize (turn on the income stream) when they're ready.

There are three main product types, each with a different risk-return trade-off.

• Fixed annuities (MYGAs) pay a guaranteed interest rate for a set term, similar to a CD. Current top rates land between 4.5% and 5.25% APY on 3-7 year terms. Principal is fully protected.
• Fixed-indexed annuities credit interest based on a market index (S&P 500, Russell 2000, etc.) with a cap on upside and a 0% floor. You never lose money when the index drops, but you don't capture the full gain when it rises.
• Variable annuities invest in mutual-fund-like sub-accounts. Upside is uncapped, but your principal can lose value. Fees are higher (2-3% per year all-in). Best for investors who want growth potential and an income rider for downside protection.

The tax treatment depends on how the annuity was funded:

• Non-qualified annuity (after-tax dollars): Only the earnings portion of each payment is taxed as ordinary income. The principal portion comes back to you tax-free.
• Qualified annuity (pre-tax dollars, like an IRA rollover): Every dollar of income is taxed as ordinary income — you never paid taxes on the contributions, so you owe on the full withdrawal.

Earnings grow tax-deferred while inside the annuity, which lets you compound without the annual drag of paying taxes on interest. For high earners, that can be worth 1-2% of additional return per year vs. a taxable brokerage account.

Note: Withdrawals before age 59½ may trigger a 10% IRS penalty on the earnings portion, similar to an IRA.

Annuities aren't for everyone. They make the most sense for someone who:

• Is within 10 years of retirement and wants to lock in guaranteed income.
• Already maxes out 401(k) and IRA contributions but wants more tax-deferred growth.
• Worries about outliving savings (longevity risk).
• Wants to protect a portion of retirement savings from market volatility.

Skip annuities if you're under 50, carry high-interest debt, or haven't maxed out your employer 401(k) match. The opportunity cost is usually too high.

Four things that separate a good annuity from a bad one:

• Surrender period. Most deferred annuities lock you in for 5-10 years. Withdrawing more than 10% per year during that window triggers a surrender charge (typically 7-10% year one, declining to zero).
• Rider fees. Income riders and death-benefit riders usually add 0.8-1.5% in annual fees. Make sure the guarantee is worth the cost.
• Participation rate, cap, and spread on indexed annuities. These three levers determine how much index growth you actually capture. A 100% participation rate with a 10% cap beats a 50% participation rate with no cap in most market years.
• M&E fees on variable annuities. Mortality and expense charges average 1.25% per year on top of the sub-account expenses. Combined costs can exceed 3% annually — make sure the guarantees justify the drag.