A fixed annuity is a contract between an investor, or annuitant, and an insurance company. The investor contributes money to the annuity in exchange for a guaranteed interest rate during the annuity’s accumulation phase and a predictable income stream during its payout phase.

Key Takeaways

Fixed vs. Variable Annuities

So how do annuities work? It varies according to type. Fixed annuities promise to provide a guaranteed rate of return regardless of market fluctuations. Variable annuities, by contrast, are tied to mutual funds and other market-based securities chosen by the buyer, and they fluctuate in value accordingly. This is why many risk-averse investors choose fixed annuities for retirement. Their slower growth is the price investors pay for the security of a set interest rate.

Immediate vs. Deferred Fixed Annuities

The income from a fixed annuity can be either immediate or deferred. With an immediate annuity, the buyer makes a single, lump-sum payment to the insurance company. Payouts begin almost immediately, and they usually continue for the rest of that person’s life.

Immediate annuities are often attractive to retirees or soon-to-be retirees who are worried about potentially outliving their resources. An immediate annuity is also an option for someone who has received a large, one-time windfall, such as an inheritance or profits from selling a business, and wants to convert it into an income stream.

A deferred annuity, on the other hand, will begin its payouts at some point in the future chosen by the buyer. With a deferred annuity, the annuitant either contributes a lump sum, makes a series of contributions over time, or does some combination of the two. These kinds of annuities are aimed at people who are still some years from retirement and don’t need the income right away.

Fixed Annuity Payouts

When an investor is ready to start receiving an income stream from their annuity, they notify the insurance company. The insurer’s actuaries then calculate the amount of the periodic payment. This calculation includes such factors as the dollar value of the account, the annuitant’s current age and life expectancy, the likely future returns on the account’s assets, and whether or not the annuity is intended to provide income to a spouse after the annuitant dies.

Generally, the longer the annuitant waits before taking annuity payouts, the larger the payouts will be. Most annuitants choose to receive monthly payments for the rest of their lives and their spouse’s life, through a joint and survivor annuity. Once both are deceased, the insurer typically stops the payouts altogether.

Therefore, if an annuitant lives for a long time, the value they get from their annuity could be more than they paid for it. If they die too soon, however, they may collect less than they paid in. Nonetheless, both scenarios accomplish the main selling point of an annuity: income for the rest of life, however long or short it turns out to be.

Annuities may also include additional provisions, such as a guaranteed number of payout years. With this option, if the annuitant and their spouse die before the guaranteed period is over, the insurer will pay the remaining funds to the couple’s heirs. Generally speaking, the more provisions included in an annuity contract, the smaller the monthly payouts will be.

Annuities have downsides: They are pricier than many other retirement investments, and any withdrawal you make during the early years may be subject to surrender fees.

How Fixed Annuities Are Taxed

Most annuities offer tax advantages. Contributions are tax deductible if the annuity is a qualified annuity, and investment earnings grow tax free until the annuitant begins to draw income from them. As with individual retirement accounts (IRAs) and other retirement accounts, those tax-deferred earnings can grow and compound more quickly over time than if the money were in a regular, taxable account.

Once the payouts start, the annuitant will have to pay taxes on them at their ordinary income tax rates—not capital gains rates, which are generally lower. That’s also true of most kinds of retirement accounts. However, the annuitant may be in a lower tax bracket by then, as many people are in retirement.

Drawbacks to Consider

Annuities, whether fixed or variable, have their downsides. Their costs tend to be high compared with those of mutual funds and certificates of deposit (CDs), for instance. Annuities are often sold through agents, and the cost of their commission is passed on to the buyer. Annuities also come with sizable annual expenses, often in excess of 2%. Any special riders will usually increase the costs.

With many deferred annuities, the annuitant may have to pay a surrender fee if they withdraw funds during the early years of the contract (typically, six to eight years or even longer). Early distributions may also be subject to tax penalties before the annuitant reaches age 59½. However, most annuities have provisions that allow penalty-free withdrawal of 10% to 15% of the account for emergency purposes.

Anyone who needs to take money from an annuity before regular payouts are supposed to begin should read their contract carefully and consider consulting a knowledgeable financial advisor.