An annuity is a contract between you (the purchaser or owner) and an insurance company. In its simplest form, you pay money to an annuity issuer, and the issuer then pays the principal and earnings back to you or to a named beneficiary. Annuities are generally used to provide income in retirement.

The biggest advantage of an annuity is that your money grows tax deferred until you withdraw it. The tradeoff is that if you take your money out before age 59½, you'll usually have to pay a 10 percent early withdrawal penalty to the IRS.

Most life insurance companies sell annuities. You pay the insurance company a sum of money, either all at once or incrementally. The type of annuity you own determines whether your money earns a fixed amount or an amount that depends on the equities in which the annuity is invested. At a designated time chosen by you, known as the maturity date, the insurance company generally begins to send you regular distributions from the annuity's account. Or, you may be able to withdraw the money over time or in one lump sum.

There are many different kinds of annuities. Four of the most common are the following:

• Single premium immediate annuity: You pay the insurance company a lump sum now and begin to receive withdrawal distributions in approximately one month and for a period of time you specify. The amount you receive will vary according to the length of time the payments are to last and whether anyone will receive the remaining balance at your death. Your money grows at a fixed interest rate, set each year by the insurance company.
• Single premium deferred annuity: You pay the insurance company a lump sum now and defer receiving withdrawals until later. The amount of those distributions will depend on the value of your account at the time your payments begin, the length of time the payments are to last, and whether anyone will receive the remaining balance at your death. Your money grows at a fixed interest rate, set each year by the insurance company.
• Annual premium deferred annuity: You send money to the insurance company usually monthly, quarterly, or annually. Your money earns a fixed interest rate, set each year by the insurance company, and you defer your withdrawals to a later date.
• Variable annuity: This type of contract is a vehicle for equity investments. You can do a one-time deposit or contribute throughout the life of the contract. You have choices as to how your money is invested in an offering of mutual funds, and you may invest conservatively or aggressively. The growth of your account value will vary, depending on your choice of investments.