Learning center · Life insurance, final expense and annuities
Annuities Explained: Types, Costs and Taxes
An annuity trades a sum of money for a promise from an insurance company. Understanding exactly what is promised, and what it costs to leave early, is most of the work.
The short answer
An annuity is a contract with an insurance company: you pay a lump sum or a series of payments, and the insurer promises either growth on a tax-deferred basis, a stream of income, or both. Immediate annuities start paying soon after purchase; deferred annuities grow first and pay later. Fixed annuities credit a stated interest rate, indexed annuities credit interest linked to a market index within limits such as caps and participation rates, and variable annuities rise and fall with the investments you choose. Most deferred annuities charge a surrender charge if you take out more than a set amount in the early years. Withdrawals of earnings are taxed as ordinary income, and taking them before age 59½ can add a 10% additional tax.
- All annuities are regulated by state insurance departments; variable and registered index-linked annuities are also regulated by the SEC and FINRA.
- Growth is tax-deferred, but earnings are taxed as ordinary income when withdrawn.
- Surrender periods on variable annuities can run eight years or more, according to FINRA.
- Indexed annuities limit upside through caps and participation rates, and limit losses through floors or buffers.
- Variable annuity free-look periods are usually 10 to 30 days, according to the SEC.
What an annuity is
FINRA, the broker-dealer regulator, describes annuities as contracts with insurance companies that people consider when planning for retirement or turning savings into a stream of income, and notes that money in them grows on a tax-deferred basis. That means you do not pay tax on growth each year; you pay when money comes out.
There are two timing choices. An immediate annuity starts paying income shortly after you buy it, in exchange for a lump sum. A deferred annuity has an accumulation phase, when the money grows, and a later payout phase, when you can take withdrawals or turn the balance into income. Many people in their 50s and 60s use deferred annuities to set aside money for later; people already retired sometimes use immediate annuities to cover a fixed monthly gap, such as the difference between Social Security and their bills.
Fixed, indexed and variable
| Type | How it grows | Main risk to you | Regulated by |
|---|---|---|---|
| Fixed | A stated interest rate set by the insurer for a period | Inflation and the insurer's ability to pay; surrender charges if you leave early | State insurance department |
| Indexed | Interest linked to a market index, limited by caps or participation rates | Complex crediting; upside limited; some can lose value; surrender charges | State insurance department; also SEC and FINRA when registered |
| Variable | Rises and falls with investment subaccounts you choose | Investment losses; ongoing fees | State insurance department, plus SEC and FINRA |
Source: FINRA, Annuities; SEC Investor.gov, Variable Annuities and Indexed Annuities bulletin. Checked October 19, 2026.
How indexed annuity limits work
The SEC's investor bulletin on indexed annuities explains the main features with simple examples. With a participation rate of 75% and an index gain of 10%, the annuity is credited 7.5%. A rate cap is the most you can be credited in a period, whatever the index does. On the downside, a floor limits loss to a set percentage: with a 10% floor and a 12% index fall, you lose 10%. A buffer absorbs the first part of a loss instead: with a 10% buffer and a 12% fall, you lose 2%. The bulletin is plain that you can lose money buying an indexed annuity, and that some, particularly those that are securities, specify losses when the index falls. Read the contract, and the prospectus if there is one.
Variable annuity fees
The SEC's variable annuities page lists the usual charges: a mortality and expense risk charge, for example 1.25% of contract value per year, administration fees, fund expenses inside the subaccounts, and the cost of any optional riders. It also notes that these fees may go toward the seller's compensation. Add them up before comparing a variable annuity with other ways to invest.
Surrender charges, free withdrawals and free-look periods
A surrender charge is a fee for taking out more than allowed, or cancelling, during the early years of a deferred annuity. FINRA warns that variable annuities can have surrender periods of eight years or more. The NAIC's Buyer's Guide to Fixed Deferred Annuities explains that many contracts allow a free withdrawal, often up to 10% of the value a year, without a surrender charge.
A free-look period lets you cancel a new contract for a refund. The SEC says the free-look period for variable annuities is usually 10 to 30 days after you receive the contract, and that the refund may be adjusted up or down for investment performance. The contract itself must state how long your free-look period is. Read it as soon as the contract arrives.
A rule of thumb worth keeping: money you may need in the next several years, for a roof, a car or a health event, generally belongs outside a deferred annuity with a surrender period. Keep an emergency fund separate.
How annuities are taxed
For an annuity bought with after-tax money (a nonqualified annuity), you get your own contributions back tax free and pay ordinary income tax on the earnings. IRS Publication 575 explains how withdrawals and annuity payments are split between the two. For contracts bought directly from an insurer, Publication 575 says withdrawals are allocated first to earnings, the taxable part, and then to your cost.
If you take money out before age 59½, Publication 575 describes a 10% additional tax on the taxable part of most early distributions, with listed exceptions. An annuity held inside an IRA follows the IRA's rules instead. Because income from an annuity can raise your adjusted gross income, it can also affect Medicare premiums through IRMAA two years later; see our IRMAA guide.
This is general information, not tax advice. A tax preparer should look at any annuity purchase or withdrawal before you act.
Questions to ask before buying
- What problem is this solving: growth, guaranteed income, or protecting principal? Is an annuity the simplest way to solve it?
- How long is the surrender period, what is the charge in each year, and how much can I withdraw each year without one?
- For an indexed annuity, what are the current cap and participation rate, and can the insurer change them each year?
- For a variable annuity, what is the total yearly cost, including the mortality and expense charge, fund expenses and riders?
- How long is the free-look period, and what refund would I get?
- How will withdrawals be taxed, and how could they affect my Medicare premiums?
- Is the person selling it licensed? South Dakota's Division of Insurance offers a license lookup for producers and companies.
If you have a complaint or a question about an insurance company, the South Dakota Division of Insurance takes consumer complaints and lists its contact details on its consumer page.
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We can walk through how an annuity would fit with your Social Security, savings and Medicare costs, and compare the options we offer, with every surrender charge and fee on the table.
Book a conversation →Questions, answered
What is an annuity?
A contract with an insurance company. You pay a lump sum or a series of payments, and the insurer promises tax-deferred growth, a stream of income, or both, under the terms of the contract.
What is the difference between an immediate and a deferred annuity?
An immediate annuity starts paying income soon after you buy it. A deferred annuity grows first and pays out later, either as withdrawals or as income you choose to start.
How does an indexed annuity work?
It credits interest linked to a market index, limited by features such as a participation rate or a rate cap. The SEC's example: with a 75% participation rate and a 10% index gain, the annuity is credited 7.5%.
What is a surrender charge?
A fee for withdrawing more than the contract allows, or cancelling, during the early years of a deferred annuity. FINRA says variable annuity surrender periods can run eight years or more.
Can I cancel an annuity after I buy it?
During the free-look period stated in your contract. The SEC says the free-look period for variable annuities is usually 10 to 30 days after you receive the contract.
How are annuity withdrawals taxed?
For an annuity bought with after-tax money, earnings are taxed as ordinary income when withdrawn and your own contributions come back tax free. IRS Publication 575 describes a 10% additional tax on the taxable part of most withdrawals before age 59½.
Who regulates annuities in South Dakota?
All annuities are regulated by state insurance regulators, which in South Dakota is the Division of Insurance. Variable annuities and registered index-linked annuities are also regulated by the SEC and FINRA.
Can an annuity affect my Medicare premiums?
It can. Taxable annuity income raises adjusted gross income, and Medicare's IRMAA surcharge is based on income from two years earlier.
Figures and sources
Every figure on this page, where it comes from, and the period it covers. Checked October 19, 2026.
| Figure | Source | Period |
|---|---|---|
| Annuities grow tax-deferred; all regulated by state insurance commissioners, with variable annuities and RILAs also regulated by the SEC and FINRA; immediate or deferred; variable annuity surrender periods of eight years or more | FINRA, Annuities | Checked October 19, 2026 |
| Variable annuity free-look period usually 10 to 30 days; mortality and expense risk charge example 1.25% a year | SEC Investor.gov, Variable Annuities | Checked October 19, 2026 |
| Participation rate example: 75% x 10% index gain = 7.5% credited; floor example: 10% floor, 12% fall = 10% loss; buffer example: 10% buffer, 12% fall = 2% loss | SEC Investor.gov, Updated Investor Bulletin: Indexed Annuities | Checked October 19, 2026 |
| Free withdrawal often up to 10% a year without a surrender charge | NAIC, Buyer's Guide to Fixed Deferred Annuities | Current printing |
| 10% additional tax on the taxable part of most nonqualified annuity distributions before age 59½ | IRS, Publication 575, Pension and Annuity Income | Current publication (2025 tax year) |
| South Dakota Division of Insurance: consumer complaints and producer/company license lookup | South Dakota Division of Insurance | Fetched October 19, 2026 |
Official sources
- FINRA: Annuities
- SEC Investor.gov: Variable Annuities
- SEC Investor.gov: Updated Investor Bulletin, Indexed Annuities
- NAIC: Buyer's Guide to Fixed Deferred Annuities
- IRS: Publication 575, Pension and Annuity Income
- South Dakota Division of Insurance: Consumer information
- South Dakota Division of Insurance: License lookup
How this guide is made: the Big Sioux Benefits Data Desk writes from official sources and checks each figure against the page it cites. This is general education, not advice about your situation. Plan details vary; confirm costs and coverage with Medicare.gov, the agency named above, or a licensed agent.
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