The core idea: pooling longevity. Where a pension (Chapter 15) is guaranteed income your employer buys for you, an annuity is guaranteed income you buy for yourself. You give an insurer a lump sum; it pools your money with thousands of other buyers and pays income for as long as you live. Those who die early subsidize those who live long — "mortality credits" — which is exactly why an annuity can pay more than you could safely draw from the same money yourself. It's insurance against the one risk you can't diversify away: living longer than your money lasts.
The main types, simplest to most complex.
- Single-premium immediate annuity (SPIA): pay once, income starts within a year and continues for life. The cleanest, cheapest, easiest-to-compare annuity — pure longevity insurance. You can add a joint-life option (pays until the second spouse dies) or a "period certain" (guarantees payments for, say, 10 years even if you die early), each of which lowers the monthly amount.
- Deferred income annuity (DIA) / longevity annuity: pay now, income starts years later. Because the insurer holds and invests the money longer — and some buyers won't survive to collect — a modest premium today buys a large check later.
- QLAC (Qualified Longevity Annuity Contract): a DIA bought inside a traditional IRA or 401(k). Under SECURE 2.0 you can move up to $210,000 (2026, indexed) into a QLAC, and that money is removed from your RMD base until the annuity starts — which can be as late as age 85. It's a double win: it hedges a very long life and trims the RMDs (Chapter 21) that would otherwise inflate your income in your 70s. A QLAC must be a plain fixed annuity — no variable or indexed features.
- Fixed deferred annuity: like a CD from an insurer — a guaranteed interest rate for a term, tax-deferred until you withdraw.
- Fixed-indexed annuity (FIA): credits a return linked to a market index, but with a cap or participation rate that limits your upside in exchange for a 0% floor (you don't lose principal to market drops). The tradeoffs live in the fine print, and the caps can change.
- Variable annuity (VA): your money goes into market "sub-accounts," so the value rises and falls with investments. VAs often carry the highest costs — mortality-and-expense charges, fund fees, and rider fees can total 2–3%+ a year — sometimes paired with a "guaranteed lifetime withdrawal benefit" rider. Powerful in narrow cases, over-sold in many.
How annuities are taxed. This is where the "qualified vs. non-qualified" split decides everything.
- Qualified annuity (bought with pre-tax money — inside an IRA/401(k), or a rollover): every dollar that comes out is ordinary income, because none of it was ever taxed. These payments also count toward your RMDs (the QLAC exception aside). A subtle but important point: buying an annuity inside an IRA adds no extra tax deferral — the IRA is already tax-deferred — so you should buy it for the income guarantee, never for a tax benefit it can't provide.
- Non-qualified annuity (bought with already-taxed savings): only the growth is ever taxable, and the tax treatment depends on how you take the money. If you annuitize it into a stream, the IRS applies an exclusion ratio — each payment is split into a tax-free return of your principal and a taxable slice of earnings. If instead you take ad-hoc withdrawals from a deferred non-qualified annuity, the rule is LIFO: earnings come out first and are fully taxed as ordinary income (plus a 10% penalty if you're under 59½), and only after all gains are withdrawn do you reach your tax-free principal.
Two tax traps worth naming. First, annuity gains are always ordinary income, never long-term capital gains — so money that might have enjoyed 0/15/20% rates in a brokerage account is taxed at your full rate inside an annuity. Second, annuities get no step-up in basis at death: an heir who inherits a non-qualified annuity owes ordinary income tax on all the built-up gains (though the 10% early-withdrawal penalty doesn't apply to inherited annuities). Contrast that with a taxable brokerage account, whose gains are wiped clean by the step-up (Chapter 28). If leaving a tax-efficient inheritance matters, that's a real mark against annuitizing everything.
A SPIA and the exclusion ratio
At 65, John puts $100,000 of after-tax savings into a SPIA paying $600/month ($7,200/year) for life. The IRS tables put his life expectancy near 20 years, so his total expected payments are about $7,200 × 20 = $144,000. The exclusion ratio is $100,000 ÷ $144,000 ≈ 69%, so about $417 of each $600 check is a tax-free return of his own principal and only ~$183 is taxable ordinary income. That favorable split lasts until roughly age 85, when he's recovered his full $100,000 basis — after that, every dollar of each payment is taxable, but the checks keep coming for as long as he lives.
A QLAC that defers RMDs
Susan, 73, has $800,000 in a traditional IRA and doesn't need all of her required distributions. She moves $200,000 into a QLAC that will begin paying at 85. That $200,000 immediately drops out of her RMD calculation, shrinking the taxable distributions (and the IRMAA pressure) she faces through her 70s and early 80s. Then at 85 — precisely when she's most at risk of having spent down the rest — the QLAC switches on a large, guaranteed lifetime income. She's used the tax code to buy insurance against her own longevity.
The other use: an annuity as a pure tax-deferral wrapper. Everything above treats an annuity as income insurance. There is a second, very different use that has nothing to do with guaranteed income: buying a stripped-down deferred variable annuity, investing it in ordinary mutual funds, and never annuitizing it at all. Strip out the lifetime-income riders and death-benefit guarantees that make most VAs expensive, and what's left is essentially a tax-deferred investment account with no contribution limit. The industry calls these investment-only variable annuities (IOVAs). Fidelity's Personal Retirement Annuity is the best-known low-cost example: a 0.25% annual annuity charge (0.10% if the contract is purchased with — or grows to — $1 million or more), against a 1.02% industry average; no surrender charges, a $10,000 minimum, and 65+ underlying funds whose own expense ratios stack on top. Deferral runs until the oldest owner turns 95 (90 in New York).
What it gives you that a 401(k) or IRA doesn't. The appeal is what's absent. There's no contribution limit and no earned-income requirement, so it's a place to shelter money after you've maxed the 401(k), IRA, and HSA. There's no forced annuitization — you can take ad-hoc withdrawals, systematic withdrawals, or a full surrender. And because it's non-qualified, there are no RMDs during your lifetime: nothing forces income out at 73. A quieter benefit that matters a great deal in this guide's terms: while the money sits inside, it throws off no annual 1099 — no interest, dividends, or capital-gain distributions land on your return. That keeps MAGI down, which is exactly the lever behind IRMAA brackets and ACA subsidies. You can also move an existing high-fee annuity into a cheaper one tax-free via a 1035 exchange.
What you give up — and why that dictates what goes inside. The price is steep and unavoidable: every dollar of gain comes out as ordinary income, on a LIFO basis (gains first, plus the 10% penalty before 59½), and there is no step-up in basis at death. Your heirs inherit the embedded gain and must empty the contract under the 5-year rule or stretch it over their life expectancy; only a surviving spouse can simply continue the contract. That combination is what makes the asset-location logic so sharp. Putting a broad stock index fund inside is usually a mistake — you'd be converting qualified dividends and long-term capital gains taxed at 0/15/20% into ordinary income, and forfeiting the step-up that would have erased the gain entirely. But an asset whose return is already ordinary income and already has little appreciation to step up loses almost nothing by moving inside. That is precisely your taxable-bond sleeve: corporate and taxable bond funds, TIPS (whose annual "phantom" inflation accretion is taxed before you receive it), high-yield, REITs, and high-turnover or actively managed strategies. This is the one genuinely defensible case for a variable annuity as an investment vehicle.
Two caveats specific to Treasuries. First, direct Treasury interest is exempt from state and local tax (Chapter 6) — wrap Treasuries in an annuity and that exemption is gone, because what comes out is annuity income, fully taxable by your state. In a high-tax state that can cancel the federal deferral benefit outright, so this favors corporate/aggregate bond funds over Treasuries, or residents of no-income-tax states. Second, a 0.25% drag against a 4.5% yield is over 5% of your return; against today's yields it's tolerable, against 2% yields it isn't. Deferral has to out-earn the fee, which generally takes 15–20+ years and works best when you're in a high bracket now and expect a lower one when you withdraw. Fill the tax-advantaged accounts first; this is an overflow tool, not a substitute.
A bond sleeve inside a 0.25% annuity
Priya, 45, is in the 32% bracket, has maxed her 401(k), IRA, and HSA, and holds a $500,000 taxable-bond sleeve yielding 4.5%. She plans to spend it starting at 65, when she expects to be in the 24% bracket. She compares leaving it in her brokerage account against moving it into a 0.25% IOVA, holding the same bond fund.
1 In the taxable account — interest taxed every year at 32%
2 Inside the annuity — nothing taxed until she withdraws, minus the 0.25% charge
3 Then she owes ordinary income tax on the whole $649,400 gain — at 24%
The wrapper is worth about $80,000 — roughly 9% more after tax — and more still if she withdraws gradually rather than all at once, since the untouched balance keeps compounding tax-deferred. But run the same math with her withdrawal bracket equal to 32% and the edge shrinks to about $28,000; with a 10-year horizon instead of 20 it nearly vanishes; and if she dies holding it, her children owe ordinary income tax on that $649,400 that a brokerage account's step-up would have erased. The wrapper earns its keep on bonds, a long horizon, and a falling bracket — change any one of those and it stops making sense.
Where annuities fit — and where to be careful. The strongest use is to cover your essential expenses: add up the baseline you must pay every month, subtract Social Security and any pension, and consider annuitizing just enough savings to guarantee the gap. That converts "will my portfolio last?" into "my needs are covered for life," which frees the rest of your money to be invested for growth and flexibility. The cautions are real, though: annuities are illiquid (surrender charges can lock money up for years), most aren't inflation-adjusted unless you buy a costly COLA rider, they carry the insurer's credit risk (state guaranty associations backstop benefits only up to limits that vary by state, often around $250,000), and the complex products carry high fees and strong sales incentives. Favor simple SPIAs and DIAs from highly rated insurers, get quotes from several carriers, consider laddering purchases over time, and annuitize a portion — not everything.
Buying an income floor
Tom and Dana, both 65, want their essential spending guaranteed for life. They buy the annuity the way you'd buy any insurance — size the need first, then shop it.
1 Size the gap
2 Price the income
A 2026 joint-life SPIA for a 65-year-old couple quotes around $500/month per $100,000 — less than the $575–650 a single life gets, because it must cover two lives. To buy $2,500/month:
3 Shop it, and split the credit risk
They collect quotes from several A-rated insurers (identical contracts can differ 5–10%) and split the $500,000 across two carriers to stay within their state guaranty limit (often ~$250,000 each).
They annuitize $500,000 of their $1.2M; the SPIA plus Social Security now covers 100% of essentials for both lives, and the remaining $700,000 stays invested for growth, flexibility, and heirs. "Will our portfolio last?" becomes "our baseline is guaranteed." The caveat: a plain SPIA isn't inflation-adjusted — a COLA rider would cut the starting check ~20–30%, so many buyers instead ladder purchases as they age and rates change.