Annuities explained: types, costs and how they pay
An annuity is a contract with an insurance company that can turn savings into income. Immediate versus deferred, fixed, indexed and variable, a worked surrender charge example in dollars, federal and Colorado taxes and the questions to ask.
An annuity is a contract between you and an insurance company. The Colorado Division of Insurance describes it as a contract in which the insurer makes a series of income payments at regular intervals in return for the premium or premiums you paid, often bought for future retirement income (Colorado Division of Insurance, doi.colorado.gov/insurance-products/life-insurance-annuities). Annuities mainly do two jobs: turning savings into income you cannot outlive, and letting money grow tax deferred until you need it. They come with trade-offs, including limited access to your money in the early years and surrender charges, and every contractual promise depends on the claims-paying ability of the insurance company. An annuity is not a bank deposit and is not FDIC insured.
Immediate or deferred
The first question is when payments start. The Colorado Division of Insurance defines an immediate annuity as one where income payments start right away, and no later than one year after you pay the premium, and a deferred annuity as one where income payments are not scheduled to start for several years (Colorado Division of Insurance, doi.colorado.gov/insurance-products/life-insurance-annuities). A single premium annuity takes one payment; a flexible premium annuity takes several.
One decision deserves extra care. When you choose to annuitize, meaning convert the contract into a stream of regular income payments, the Division notes that the decision cannot be changed: you can no longer change the payment terms, and you no longer have access to the money outside the payment plan you chose (doi.colorado.gov/insurance-products/life-insurance-annuities). That permanence is what makes lifetime income possible, and it is why annuitizing should only involve money you will not need as a lump sum.
| Type | How it works | Often used for |
|---|---|---|
| Immediate (income) annuity | You pay a lump sum and income begins within one year | Covering essential expenses for life starting now |
| Deferred annuity | Money accumulates first; income or withdrawals start later | Tax-deferred accumulation before retirement income begins |
Fixed, fixed indexed and variable
The Division describes a fixed annuity as one where your money, less any charges, earns interest at rates set by the insurer or in a way the contract specifies. An equity indexed (fixed indexed) annuity is a variation of a fixed annuity where interest is based on an outside index such as a stock market index. A variable annuity invests your money in separate accounts you direct, and if those investments do poorly you may lose some or all of your money (Colorado Division of Insurance, doi.colorado.gov/insurance-products/life-insurance-annuities).
Variable annuities are securities as well as insurance contracts. The SEC's investor education site explains that a variable annuity comes with a prospectus, that its subaccounts can lose value, and that typical charges include a mortality and expense risk charge calculated as a percentage of contract value, such as 1.25% a year, along with surrender charges and optional benefit fees (SEC Investor.gov, investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/variable-annuities). Fixed and fixed indexed annuities do not have subaccounts and are regulated as insurance products by the Colorado Division of Insurance.
| Type | How interest or value is determined | Regulated as |
|---|---|---|
| Fixed annuity | The insurer credits a declared interest rate for a set period, with a minimum rate stated in the contract | An insurance product, regulated by the Colorado Division of Insurance |
| Fixed indexed annuity | Interest is linked to a market index, subject to caps, participation rates or spreads, with a floor that protects credited value from index losses | An insurance product, regulated by the Colorado Division of Insurance |
| Variable annuity | Value rises and falls with the subaccounts you choose; charges such as an M&E risk charge apply | A security as well as an insurance product; sold with a prospectus and requires a securities license |
Payout options
- Life only: payments for your lifetime, ending at death. Usually the highest payment per dollar.
- Joint and survivor: payments continue for a spouse after the first death, usually at a lower amount per payment.
- Period certain: payments for a set number of years, to you or your beneficiary.
- Life with period certain or refund: lifetime payments, with a minimum paid to your beneficiaries if you die early.
- Income riders on deferred annuities: a lifetime withdrawal benefit added for an annual charge, without annuitizing the account.
Surrender charges: a worked example in dollars
Most deferred annuities charge a surrender charge if you take out more than a penalty-exempt withdrawal amount during the surrender period. The SEC describes the surrender charge as generally a percentage of the amount withdrawn or of purchase payments, typically declining over several years (SEC Investor.gov, investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/variable-annuities). Each contract states its own schedule, and many allow a set percentage of the value to be withdrawn each year without a charge.
Hypothetical Colorado household, not a real client. A 54-year-old Adams County resident places $100,000 of savings (not IRA money) in a deferred fixed annuity. To show how the math works, assume a seven-year surrender schedule of 7%, 6%, 5%, 4%, 3%, 2% and 1%, with 10% of the contract value available each year without a charge, and the charge applied only to the amount above that. This schedule is an illustration built for this guide, not a product or a quote; real contracts differ in length, percentages and how the charge is calculated.
If the owner surrendered the whole contract while the value was still $100,000, the charge would apply to $90,000 (everything above the $10,000 penalty-exempt amount). The table shows what that would cost in each year of the illustration. Some contracts also apply a market value adjustment that can raise or lower the amount received, which is not shown here.
| Contract year | Surrender charge rate | Amount subject to the charge | Charge on a full surrender |
|---|---|---|---|
| 1 | 7% | $90,000 | $6,300 |
| 2 | 6% | $90,000 | $5,400 |
| 3 | 5% | $90,000 | $4,500 |
| 4 | 4% | $90,000 | $3,600 |
| 5 | 3% | $90,000 | $2,700 |
| 6 | 2% | $90,000 | $1,800 |
| 7 | 1% | $90,000 | $900 |
| 8 and later | 0% | None | $0 |
The same example with taxes
Taxes are a separate cost. For a non-qualified annuity (one bought with after-tax money, like this one), IRS Publication 575 says amounts withdrawn before the annuity starting date are allocated first to earnings, which are taxable, and then to your cost, which is not, for contracts bought after August 14, 1982. It also says most distributions from nonqualified annuity contracts made before age 59 and a half are subject to an additional tax of 10% on the part included in gross income, with listed exceptions (IRS Publication 575, irs.gov/publications/p575).
Continue the hypothetical. In contract year 4 the owner is 58, the value has grown to $112,000, and the owner withdraws $20,000. The penalty-exempt amount is 10% of $112,000, or $11,200, so $8,800 is subject to the 4% charge: a $352 surrender charge. Because withdrawals come out of earnings first, the first $12,000 of earnings is taxable, so $12,000 of the $20,000 is ordinary income and $8,000 is a return of premium. At 58, the 10% additional tax applies to the $12,000 taxable part, adding $1,200 to federal tax. Waiting past 59 and a half, and past the surrender period, would have avoided both the $352 and the $1,200.
| Item | Amount | How it is figured |
|---|---|---|
| Penalty-exempt amount | $11,200 | 10% of $112,000 (illustration assumption) |
| Amount subject to surrender charge | $8,800 | $20,000 minus $11,200 |
| Surrender charge at 4% | $352 | $8,800 x 4% |
| Taxable part (earnings first) | $12,000 | IRS Publication 575 allocation for nonqualified contracts |
| 10% additional federal tax before 59 and a half | $1,200 | $12,000 x 10% |
| Regular income tax | Depends on bracket | Ask your tax professional |
Taxes in plain English
- Growth in a non-qualified annuity is tax deferred until you withdraw it.
- Withdrawals of earnings are taxed as ordinary income, not capital gains, and come out earnings first for contracts bought after August 14, 1982 (IRS Publication 575, irs.gov/publications/p575).
- Earnings withdrawn before 59 and a half generally face an additional 10% federal tax, with exceptions listed in Publication 575.
- An annuity inside an IRA gets no extra tax deferral; it is bought for the income or protection features, and required minimum distribution rules still apply, generally starting at 73 (IRS, irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs).
- Colorado: payments from a privately purchased annuity that has fully matured qualify for Colorado's pension and annuity subtraction, generally up to $20,000 a year at ages 55 to 64 and $24,000 at 65 or older, shared with other qualifying retirement income (Colorado Department of Revenue, tax.colorado.gov/sites/tax/files/documents/ITT_Social_Security_Pensions_and_Annuities_Jan_2025.pdf).
- Talk with your tax professional before moving retirement money.
Colorado protections when you buy
Colorado Regulation 4-1-11, as amended effective November 1, 2022, requires producers to act in the best interest of the consumer when recommending an annuity, and requires insurers to maintain a system to supervise recommendations so that the consumer's insurance needs and financial objectives at the time of the transaction are addressed. The amendment aligned Colorado with the National Association of Insurance Commissioners model regulation (Colorado Division of Insurance, doi.colorado.gov/announcements/notice-of-adoption-of-amended-regulation-4-1-11-concerning-best-interest-obligations). In practice that means an agent should gather your financial information, explain why a recommendation fits, and document it.
You also get a period after delivery to cancel the contract for a refund. The SEC notes this right-to-cancel period is usually 10 to 30 days and that the contract should prominently state how long it is and how to return the contract (SEC Investor.gov, investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/variable-annuities). Read your contract for the exact number of days that applies to you.
If an insurer fails, state guaranty associations provide a safety net within limits. NOLHGA, the national organization of those associations, says the association in the state where the contract owner lives provides coverage subject to exclusions and limits, and that in most states the coverage level for a fixed annuity is $250,000 in present value of annuity benefits, including cash surrender values (NOLHGA, nolhga.com/policyholders/faqs-product-coverage/). Confirm the Colorado limit with the Colorado association before relying on it, and remember that this safety net is not a reason to choose any contract; the insurer's own financial strength comes first.
How an annuity fits into a retirement budget
The most useful way to think about an annuity is as one possible answer to a specific gap, not as a place to park money. Start by listing your essential monthly expenses: housing, food, utilities, insurance premiums including Medicare, and transportation. Then list the income that lasts as long as you do, which for most people means Social Security and, for some, a pension. If lifetime income already covers the essentials, an income annuity has less work to do. If there is a gap, an immediate annuity or an income rider can be one way to close it, alongside other choices such as delaying Social Security, working part time or lowering fixed costs.
The retirement planning checklist on this site walks through a worked monthly budget for a hypothetical Brighton couple using exactly this test. Whatever the answer, keep an emergency reserve outside any annuity, and size any annuity purchase so that the money left accessible covers the surprises retirement brings, such as a roof, a car or a hospital deductible.
When an annuity may fit, and when it may not
| May fit | May not fit |
|---|---|
| You want part of your income to last for life, alongside Social Security | You may need the money within the surrender period |
| You have used other tax-deferred options and want more deferral | You have no emergency fund outside the annuity |
| You want to protect part of your savings from market losses | You do not understand how the contract credits interest or what the charges are |
| You are past 59 and a half or will not need the earnings before then | You are under 59 and a half and may need the earnings soon |
What Lisa checks for you
Annuities are discussed as part of Lisa's no-cost retirement planning review, and the review starts with income, not products. The steps follow the same order every time, and you leave with the numbers in writing so you can take your time, talk it over with family or your tax professional, and decide without pressure. Saying no to an annuity is a perfectly good outcome of the review.
- Your monthly essentials versus income that lasts for life (Social Security, pensions), to see whether there is a gap an income annuity could fill.
- How much money must stay accessible for emergencies and planned expenses, so nothing you may need sits inside a surrender period.
- Your age relative to 59 and a half and to your RMD age, and whether the money is IRA or after-tax savings.
- The full surrender schedule, the penalty-exempt withdrawal amount, any market value adjustment and every rider charge, in writing.
- For indexed contracts: the cap, participation rate or spread, how long each is set for, and the contractual minimum.
- If you are replacing an existing annuity: the surrender charge on the old contract, the new surrender period you would start, and what benefits you would give up.
- The insurer's financial strength, and that beneficiaries are named correctly.
Questions to ask before you sign
The Colorado Division of Insurance publishes its own list of questions for buyers, and it is a good checklist to bring to any meeting (Colorado Division of Insurance, doi.colorado.gov/insurance-products/life-insurance-annuities).
- What is the contractual minimum interest rate?
- What charges are deducted from my premium or contract value, and when?
- What are the surrender charges if I end the contract early, and for how many years do they apply?
- Can I take a partial withdrawal without charges or losing earned interest?
- Does the contract waive withdrawal charges if I am confined to a nursing home or diagnosed with a terminal illness?
- What income payment options do I have, and when?
- What are the terms of the death benefit?
- For indexed annuities: what is the participation rate, the cap and any spread or fee, how long are they set, and which indexing method is used?
- What is your commission on this product?
The bottom line
An annuity can be a sensible way to turn part of your savings into income you cannot outlive, but only when the money can stay put through the surrender period and the contract is clear to you. Ask for the surrender schedule in dollars, check your age against 59 and a half, and use the Division of Insurance questions. As part of a no-cost retirement planning review, Lisa starts with your income needs and only then looks at whether an annuity belongs in the plan. Send Lisa a message or call (303) 887-8584.
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Sources
- Colorado Division of Insurance: Life Insurance and Annuities, Colorado Division of Insurance
- Colorado Division of Insurance: Notice of adoption of amended Regulation 4-1-11 (August 2, 2022), Colorado Division of Insurance
- IRS Publication 575, Pension and Annuity Income, Internal Revenue Service
- SEC Investor.gov: Variable annuities, investor.gov
- NOLHGA: FAQs, product coverage, nolhga.com
- Colorado Department of Revenue: Income Tax Topics, Social Security, Pensions and Annuities (January 2025), State of Colorado
- IRS: Retirement plan and IRA required minimum distributions FAQs, Internal Revenue Service
Please note: Final expense, annuity and supplemental products are subject to underwriting and carrier approval. Guarantees are based on the claims-paying ability of the issuing company. Nothing on this site is tax, legal or investment advice.