An annuity is essentially the opposite of a life insurance policy. Life insurance policies pay off when you die; an annuity  pays off if you live.

Best used as a retirement-planning vehicle every annuity has two phases: the accumulation phase and the annuitization phase. In the accumulation phase, you give money to an insurance or investment company over a period of time or in a lump sum, and it earns a rate of return. In the annuitization phase, you begin to withdraw regular payments (such as monthly or annually) from your contract until you die.

An annuity has a death benefit, although it is not like one found in a life insurance policy. If you die before you annuitize, your beneficiary will receive either the current value of your annuity or the amount you have paid into it, whichever is greater. For example, if you die when your investments are performing poorly and your account value is less than what you have paid in, your beneficiary would receive the amount you paid in.

Once you begin to receive monthly payments, you no longer have a death benefit on your contract. For example, if you annuitize at age 65 and die at age 67, the insurance company keeps your money in your contract. However, you can buy "term certain" annuities, which guarantee that either you or your beneficiary will receive payments for a certain period of time, such as 10 to 15 years. For example, if you died three years after you began receiving payments from a 10-year term certain annuity, your beneficiary would still receive payments for the next seven years.

The money in your annuity grows tax-deferred, meaning that the money is not taxable until you begin to receive payments from your annuity. Once you receive payments, your gains are taxed at your ordinary income tax rate. If you die before you annuitize, your beneficiary pays taxes on the death benefit. In either case, the person who receives the money (the annuity holder or your beneficiary) is taxed at his or her ordinary income tax rate.

The ideal annuity buyer is 55 or older since annuities are less attractive to younger investors because there is a 10 percent penalty tax if you withdraw money from your annuity before age 59½ for reasons other than death or disability. However, many people who have already retired and need annuity income right away opt for immediate annuities, which skip the accumulation phase and begin to issue payments as soon as you invest in the contract. The ideal annuity buyer is a person who has already contributed the maximum amount to their existing tax-deferred retirement plan, such as a 401(k), 403(b), or IRA. That's because you are already building up tax-deferred money in those plans, and those savings vehicles cost much less than an annuity.

There are three kinds of annuities and each differ in how the money in your contract is invested.

• Fixed annuity. The money you invest earns a fixed rate of interest that is guaranteed by the insurance company. The upside is that there is no risk involved. The downside is that you will miss out on any gains you could have made if the stock market performs well. When you annuitize, your payments are also fixed.
• Variable annuity.Your money is placed in investment options known as subaccounts, which are similar to mutual funds. Each subaccount has its own degree of risk, ranging from aggressive growth funds to bond funds. The upside is that you have the opportunity to make substantial gains, depending on the performance of your investment. The downside is that you will lose money if your investments perform poorly. Another VA downside: It may cost you to switch your money among subaccounts. When you annuitize, your payments fluctuate depending on the performance of your investments. Some VA's allow "fixed annuitization," in which you receive fixed payments. The insurance or investment company recalculates your payments each year based on the performance of your investments.
• Equity-indexed annuity.Your money is invested in a fixed account and you may earn additional interest based on the performance of a particular stock index, such as the Standard & Poor's 500 Index, the Dow Jones Industrial Average, the NASDAQ Composite Index, or the Russell 2000 Index. The upside is that you get the best of both worlds — the opportunity to earn money from stocks and the stability of a fixed account. For risk averse investors who wish to participate in a portion of the market gains without the downside this type of contract is ideal.

If you buy an annuity and then decide you want to get out of the contract, you can surrender your annuity. Most companies charge you a surrender fee if you decide to get out your annuity within the first seven to eight years of owning it. The shorter amount of time you are in the annuity, the more you'll pay in surrender fees. For example, if your annuity has a seven-year surrender period, and you surrender your annuity in the first year, you may pay seven percent of the value of your investment to the company. If you surrender in the second year, you may pay 6 percent, and so on.

If you want to switch one annuity for another, you can do so without paying taxes. Exchanging one contract for another is known as a 1035 exchange (named after Section 1035 of the federal tax code). In a 1035 exchange, you can exchange a life insurance policy for another life insurance policy, an annuity for another annuity, or a life insurance policy for an annuity without paying taxes. However, you cannot exchange an annuity for a life insurance policy without paying taxes on the gains in your contract.

If you need to tap into your money before the surrender period, some insurers will allow you to access a small percentage of your investment, about 10 to 15 percent, under certain circumstances, such as serious illness or disability. After the surrender period, you can withdraw as much out of your annuity as you want. However, if you take out that money before age 59½, it is subject to 10 percent penalty tax.