What is an annuity, and who should buy one?

Annuities are investment products sold by life insurance companies that provide an income stream during retirement. You purchase an annuity, and in return the insurer makes payments to you in the future. Payments continue either for a certain number of years or until you die.

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You can purchase either an immediate or deferred annuity:

• Immediate annuity. You pay money to the insurer upon retirement or close to retirement. Then, the insurance company starts doling out payments to you.
• Deferred annuity. The money is invested and accumulates until you're ready to take withdrawals during retirement.

The annuity you purchase will either be fixed or variable. A fixed annuity guarantees a minimum rate of return. A variable annuity bases the payouts on the performance of investments. A variable annuity has the potential for greater returns but also is a riskier investment than a fixed annuity.

Annuities build up money tax-deferred and they don't have IRS investment limits. So, they can be attractive for people looking for additional ways to save for retirement. Many financial experts recommend people consider annuities only after they have maxed out tax-advantaged contributions to other retirement plans.

Potential complications with annuities

A lifetime income stream is one of the biggest selling points of annuities. But many people buy annuities without understanding all the terms and conditions. Insurance brokers who sell annuities make commissions, so it's important to see through the sales pitches and research the investment thoroughly before you buy.

Also beware of the fees. You'll pay a broker's commission when you purchase an annuity and a surrender fee if you take the money out of the annuity before a certain date. You also will face a tax penalty if you withdraw money before age 59 1/2.

For more, see "How to make sure your cash lasts as long as you do."