6 Questions to Ask Before You Buy an Annuity

6 Questions to Ask Before You Buy an Annuity

An annuity is an insurance contract, not an investment account. That single distinction explains most of what confuses people about them, including why the fees are structured the way they are and why getting your money back early can cost you.

Annuities are not automatically bad. Some do a job nothing else does as cleanly. But they are sold far more often than they are shopped, and the questions below are the ones that separate a contract doing real work from a contract doing commission work.

Ask all six. Get the answers in writing.

1. What Problem Is This Contract Solving?

The short answer: an annuity is worth considering when you need to convert a pile of money into income you cannot outlive. That is longevity risk, and pooling it with an insurer is a legitimate thing to buy.

An income floor is the other defensible job. If your essential expenses exceed Social Security and any pension, guaranteed lifetime income for the gap can make the rest of the portfolio easier to invest sensibly, because you are no longer forced to sell into a bad market to buy groceries.

What is usually not a good enough reason: "market protection." Downside protection inside an annuity is purchased with capped upside, credited-interest formulas, and fees. That may still be a trade you want, but price it as the trade it is rather than as free safety. If the salesperson cannot name the specific problem in one sentence, there may not be one.

2. How Is the Person Selling This Paid?

Annuity compensation varies enormously and it is rarely volunteered. Commissions on some contracts can run into high single-digit percentages of the premium, paid by the insurer, which is why the product does not appear to cost you anything at purchase.

Ask directly: what is your total compensation on this contract, in dollars, including any trail? Then ask the more useful follow-up: what would you recommend if you were paid a flat fee for advice instead?

A fee-only advisor with no insurance license has no financial reason to steer you either way. That does not make them right, but it does make their answer a useful second data point. Sales compensation is not disqualifying. Hidden sales compensation is.

3. What Are the Total Annual Costs, Unbundled?

Get a line-item list, not a summary. Depending on the contract type, the layers can include a mortality and expense charge, an administrative fee, the expense ratios of any underlying subaccounts, and a separate annual charge for every rider attached, including income and death benefit riders.

Indexed contracts often carry no explicit annual fee, which sounds better than it is. The cost shows up instead in the crediting formula: participation rates, caps, and spreads that limit how much of the index return you actually receive, and which the insurer can typically adjust within contractual limits.

Add it all up and compare the total against what a plain portfolio plus a simple income annuity would cost. Sometimes the packaged contract still wins. You should know by how much.

4. What Does the Surrender Schedule Cost Me in Years Three, Five, and Seven?

Most deferred annuities carry a surrender charge that declines over a period commonly running six to ten years. Withdraw more than the free withdrawal amount before it expires and you pay a percentage of what you take out.

Ask for the actual schedule by year, and ask what the free withdrawal allowance is. Then run the honest scenario: if you needed a third of this money in year four for a roof, a health event, or to help a child, what would that cost you?

Some contracts also apply a market value adjustment that can increase or decrease the amount you receive on an early surrender depending on interest rate movements. Liquidity is the thing people undervalue at signing and resent later.

5. Who Is the Insurer, and What Happens If It Fails?

An annuity's guarantee is only as good as the company behind it. Look at the insurer's financial strength ratings from the major agencies, and understand that a rating is an opinion about claims-paying ability, not a promise.

If an insurer becomes insolvent, state guaranty associations provide a backstop, but coverage is limited per contract owner per insurer and the limits vary by state. Concentrating a large amount in one carrier can put money above those limits.

This is a real reason some buyers split a large purchase across two insurers, and a real reason to be skeptical of a contract offering noticeably better terms than everything else on the market.

6. How Will This Be Taxed, for Me and for My Heirs?

Annuity taxation surprises people, so settle it before signing.

Gains inside a nonqualified annuity grow tax-deferred, but withdrawals come out gains first under last-in, first-out ordering, and those gains are taxed as ordinary income rather than at long-term capital gains rates. Withdrawals of gain before age 59 1/2 generally carry an additional 10 percent tax on top of ordinary income tax.

For heirs, the important part: annuity gains do not receive a step-up in basis at death. A beneficiary inherits the deferred gain and the ordinary-income treatment along with it, which is very different from inheriting an appreciated brokerage account. If you already own a contract you dislike, a 1035 exchange can move it to another annuity without triggering tax, though it may restart a new surrender schedule.

What the Three Main Contract Types Actually Promise

Contract type	What it promises	Main cost you are paying	Where it disappoints
Fixed or income annuity	A stated interest rate, or a set payment for life	Simplicity in exchange for giving up access to principal	No inflation adjustment unless you buy one, and you cannot change your mind
Indexed annuity	Principal protection with return linked to an index formula	Capped or limited participation in index gains	Crediting terms are complex and adjustable within limits
Variable annuity	Market participation inside a tax-deferred wrapper, often with riders	Layered annual fees, sometimes over 2 percent all in	Fees can consume much of the tax deferral benefit

Why a Tax-Aware Second Read Helps

Because so much of the annuity question is a tax question, the useful second opinion often comes from someone who works both sides.

Calculated Wealth is a Madison, Wisconsin advisory firm listed on Sam's List, founded in 2022, working with retirees. Retirement income and the tax treatment of withdrawals are the kind of intersection where reviewing a specific contract against a specific tax picture beats any general rule, including the ones above.

If you are holding an illustration right now, the most valuable next step is having someone with no stake in the sale read it. Compare advisors on how they are compensated and whether they act as a fiduciary in the Sam's List financial advisor directory before you engage anyone.

Frequently Asked Questions

Is an annuity a good idea for retirement? It depends on what you need it to do. Converting savings into income you cannot outlive, or building a floor under essential expenses, are jobs annuities do well. Buying one primarily for market protection or tax deferral is where costs often outweigh the benefit. Compare the total cost against a portfolio-plus-simple-income-annuity alternative.

How much does an annuity cost per year? It varies widely by type. Variable contracts can layer a mortality and expense charge, administrative fees, subaccount expenses, and per-rider charges, sometimes exceeding 2 percent annually in total. Indexed contracts often have no stated fee but limit returns through caps, spreads, and participation rates. Ask for every cost as a separate line item.

What is a surrender charge on an annuity? A fee for withdrawing more than the contract's free withdrawal amount before the surrender period ends, commonly six to ten years, with the percentage declining each year. Some contracts also apply a market value adjustment that changes the payout based on interest rate movements. Ask for the year-by-year schedule before signing.

Are annuity withdrawals taxed as ordinary income? Gains in a nonqualified annuity are taxed as ordinary income, not at capital gains rates, and withdrawals come out gains first. Distributions of gain before age 59 1/2 generally face an additional 10 percent tax. Annuity gains also do not receive a basis step-up at death, so heirs inherit the ordinary-income treatment.

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About the author: Kimberly Green is the cofounder of Sam's List, where business owners and high earners find vetted CPAs, financial advisors, and fractional CFOs. She's met one-on-one with 400+ financial professionals and writes from the real data behind thousands of client-advisor matches. Ask her anything about finding an accountant - she's heard it all, including the questions people are afraid to ask.