Annuities are an insurance product designed to provide income during your retirement. If having an extra source of retirement income sounds good to you, you'll need to determine whether an immediate or deferred annuity is the best choice in your situation; making the right selection can result in significantly higher returns over your lifetime.

Annuities 101

An annuity is a contract you make with an insurance company that requires it to make payments to you. When you sign an annuity contract, you can choose either an immediate or a deferred annuity. With an immediate annuity, you'll annuitize your investment at once -- meaning you'll convert that lump sum of money into a stream of future payments. Deferred annuities allow you to leave your invested funds sitting with the insurance company for years or even decades, which gives the money a chance to grow before you lock in your payment amount by annuitizing the investment (indeed, many holders of deferred annuities never do annuitize their contracts; see the below section on deferred annuities for more detail).

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Immediate annuities

With an immediate annuity, you hand over a wad of cash to the insurance company and in exchange the company starts making you monthly payments of an agreed-upon amount. An immediate annuity can be a great choice for a new retiree with lots of retirement savings who isn't comfortable managing his own investments. By paying over a large chunk of that retirement savings for an annuity contract, you're putting the responsibility for making that money perform onto the insurance company. And whether the company's investments prosper or fail, it's still required to pay you the amount specified in the annuity contract. Dumping a large portion of your retirement savings into an annuity will also help minimize your required minimum distributions (RMDs) once you turn age 70 1/2, so you're less likely to have to withdraw more money than you actually need -- though you'll need to use a special type of annuity called a qualified longevity annuity contract (QLAC) to get this particular benefit.

Deferred annuities

Unlike immediate annuities, deferred annuities allow you to put money down in advance -- in fact, you can invest in a deferred annuity long before you hit retirement age. After you hand over your money to the insurance company, it will sit in your account and accrue returns based on the terms of your annuity contract; the longer you leave your investment alone, the more it's likely to grow. 

Deferred annuities typically give you several options for getting your money, including lump-sum (you get your entire payment at once), systematic withdrawal (you periodically withdraw funds until your account is empty), and annuitization (you lock in a regular schedule of payments for a certain length of time). Check your annuity contract before you sign to see which options are available and to determine how your choice will affect how much money you get back. You'll need to wait until you're at least age 59 1/2 to trigger payments of any sort or you'll likely be hit with a 10% early withdrawal penalty by the IRS.

As long as you haven't annuitized your deferred annuity, you'll have access to the money you've contributed and can withdraw part of it or even cancel the contract -- although you may have to pay surrender fees to do so. But once you do annutize, you'll be locked into the payments set by your contract and will no longer be able to withdraw the money you've invested.

Choosing your annuity

Because deferred annuities can tie up your investment for years and often charge high fees and commissions, they're not the best option for many savers. Most workers will get better results by investing their money in a 401(k) or IRA (or even an HSA, if you qualify to contribute to one). Savers who've maxed out their contribution limits for all available tax-advantaged retirement accounts and who still have a bundle of cash to invest might consider turning to a deferred annuity as a way to delay paying taxes on that income and to provide supplemental retirement income.

On the other hand, if you've already retired or you only have a short time to go before the big day, an immediate annuity can be a good way to lock in a source of guaranteed retirement income. Using your retirement savings to buy an immediate annuity means you won't have to spend your retirement years worrying about what might happen if your investments fail or the US economy lands on the rocks. These annuities are also a great way to invest the kind of lump-sum many new retirees receive, such as a 401(k) or pension distribution.

Whichever option you choose, be sure to check the annuity contract for any surprises. Make sure you thoroughly understand all the fees involved with the contract and compare them with one or two other, similar annuity contracts to confirm that they're not excessive. Annuities can be highly complex financial contracts, and signing up for one will likely have a huge impact on your retirement years -- for good or ill. Before signing up for any annuity, make sure that you get answers to all your questions and that you fully understand what you're committing to.