What Is a Fixed Annuity?

June 23, 2021

What Is a Fixed Annuity?

June 23, 2021

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Last Updated: February 14, 2024

The predictability and stability of a fixed annuity have made it a popular choice for some saving for retirement. Annuities offer a guaranteed income stream that can help supplement your other retirement income sources, like Social Security and 401(k)/IRA distributions.

What Is a Fixed Annuity?

A fixed annuity is one in which the annuity purchaser enters a contract with an insurance company, who promises to pay a guaranteed interest rate on the principal; fixed annuities are not tied to market or portfolio performance, so they are less risky than variable annuities. Fixed annuities can be immediate or deferred, and they can be funded with a lump sum or a series of payments. The funding period until payments begin is known as the accumulation phase; after the accumulation phase ends, the contracted interest rate ends and another interest rate, called the renewal rate, is applied to the account. When the owner annuitizes their annuity, the payout phase begins when the annuitant elects to begin receiving payments and can continue for a specified amount of time or for the annuitant’s remaining lifetime. The payment amount is calculated using a variety of factors, including the annuity type, amount of money in the annuity, annuitant’s age and gender, and length of payments among other factors. Despite its name, the interest rate on a fixed annuity can change over time; the conditions of this change will be outlined in the contract—if, how, and when.

A multi-year guaranteed annuity (or MYGA) is type of fixed annuity that guarantees a fixed interest rate for a specific number of years—usually 3–10 years—as outlined in the annuity contract. MYGAs guarantee the interest rate for the entire contract duration while traditional fixed annuities may only guarantee the initial interest rate for a portion of the contract.

Tax Implications for Fixed Annuities

Fixed annuities grow tax deferred during the accumulation phase; when the contract begins paying out, the insurance company uses an exclusion ratio to determine which portion of the payout is the return of the initial premium and which portion is the gains on the earned interest. If the annuity was funded with post-tax dollars (also known as a non-qualified annuity), the initial premium paid is excluded from taxation while the gains are taxed. If the annuity was funded with pre-tax dollars (which could be from a tax-deferred retirement account like a 401(k) or IRA), the entire payment would be taxed.

Returns from fixed annuities are taxed at regular income rates; they do not get the benefit of lower capital gains tax rates.

Advantages & Disadvantages of Fixed Annuities

Tax-deferred growth – annuitants are only taxed when they take money from their account.

Predictable, stable returns with lower risk – fixed annuities are not tied to portfolio or market performance, and the principal is protected.

Guaranteed minimum interest rates – this can offer some peace of mind as protection against declining interest rates.

Illiquid product – annuities in general are mostly illiquid, making the money in your annuity essentially untouchable without paying fees (aside from the accelerated withdrawals most annuity providers offer, which is usually one per year and only for a portion of your account value).

High fees – annuities have a surrender period, a time when withdrawals of more than 10% of the account value are subject to surrender charges. There are other fees that can be included in your contract, and additional features (or riders) like death benefits or cost of living adjustments come with an extra, often high cost. Lastly, early withdrawals before the age of 59.5 also have a 10% tax penalty imposed by the IRS.

Lower growth potential – while this can be a benefit for some (see predictable, stable growth above), fixed annuities do not have the potential that riskier indexed or variable annuities have of yielding greater returns if a portfolio or index performs well.

Another Type of Fixed Annuity: Fixed Index Annuity

Fixed index annuities (or FIAs) combine the features of fixed and variable annuities—the potential for greater returns than a traditional fixed annuity with less risk than a variable annuity. The interest rate is tied to the performance of an index, like the S&P 500 or a proprietary index. However, there is a minimum guaranteed interest rate regardless of the index performance. This type of annuity is more complex and riskier but has the potential to deliver greater returns if the index performs well. The growth/return rate is subject to rate floors and caps, meaning that gains can be limited. There is a guaranteed minimum interest rate that offers protection from the downside, but there is also a maximum rate (or cap) the insurer will provide; anything over that cap will not be returned to you as a gain. While this type of annuity is benchmarked to an index, your money is never directly exposed to the market. You can indicate how you’d like your money invested—all in one index or divided across several indexes.

FIAs also have participation rates, which determine how much of your money is eligible for returns. Your earnings are calculated as a proportion of the index performance. For example, if your annuity contract has a par rate of 80% and the index performs at 10%, your earnings will be 80% of 10%, or 8%. The remaining 2% over is returned to the annuity insurer. Spreads (also called the margin) are also subtracted from your earnings. If you have a 2% spread, your total earnings will be 6% in this example. However, if you have a 2% spread and the market performs at or below that, you’ll be credited with nothing.

Traditional FIAs are designed to review and renew their rates each year, which leaves some uncertainty and risk for the annuitant. The insurer could raise, maintain, or lower the rates—you have no guarantees when you purchase the contract. This is where participate (par) rates enter the picture: You do have some guarantee and protection from rate fluctuations, but keep in mind that you’re not guaranteed to earn a return if the market performs below your contract-outlined rates.

Fixed index annuities offer many of the same benefits as fixed annuities: tax deferred status, principal protection, lifetime income guarantee, and additional riders available for a fee. They can also offer some inflation protection as returns are typically higher than other retirement assets like fixed annuities, CDs, and bonds. Fixed index annuities can be better used as long-term investments, where traditional fixed annuities may be better for those closer to retirement. Again, this type of annuity is complex; a financial professional can help you sort through the jargon and contract. Keep in mind that insurance companies do pay brokers a commission, which can make some annuity purchases wary, so do your due diligence and make sure you understand what you’re buying—and why.

Other names for fixed index annuities are equity indexed annuities, fixed indexed annuities, and indexed annuities.

1035 Exchanges for Annuities

An existing annuity, no matter the type, can be easily exchanged into a new annuity contract using a 1035 exchange. Normally, withdrawing your annuity funds before the age of 59.5 incurs a 10% penalty, but a 1035 avoids this penalty by moving your tax-deferred money from one annuity into the same tax-deferred status in another annuity. It’s important to evaluate your surrender period and charges before doing this to ensure your annuity provider will not charge you a fee to withdraw this money to do the 1035 exchange. It’s advisable to only move this money into another annuity if the new annuity is offering a higher interest rate than what you’re currently receiving.Keep in mind that annuities do not equate to ownership of individual stocks, index funds, or mutual funds. They are also not insured by the FDIC, any federal agency, or any bank. Annuities are backed by the financial strength and paying ability of the issuing company. As annuities are illiquid, they do not offer immediate or flexible access to money; they are part of long-term retirement strategy. Consult a financial professional to discuss your options.

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