What Is a Fixed Annuity
A fixed annuity is a type of annuity contract that allows for the accumulation of capital on a tax-deferred basis. In exchange for a lump sum of capital, a life insurance company credits the annuity account with a guaranteed fixed interest rate while guaranteeing the principal investment. A fixed annuity can be annuitized to provide the annuitant with a guaranteed income payout for a specified term or for life.
Breaking Down Fixed Annuity
Fixed annuities are contracts issued by life insurance companies to individuals looking for guaranteed rates of return without any risk to principal. Basically, steady, risk-free returns over a set period of time, for a fee. Because they are a type of insurance contract issued by a life insurance company, they enjoy some of the same tax benefits of life insurance policies, such as tax-deferred growth of earnings. Taxes are paid when the earnings are withdrawn or when the contract is annuitized for monthly payments.
Key Features of a Fixed Annuity
Competitive fixed yields: The rates on fixed annuities are derived from the yield a life insurance company generates from its investment portfolio, which is invested primarily in high-quality corporate and government bonds. The yield on fixed annuities is typically higher than the yield on equivalent risk-free investments and is often guaranteed for a period of one to 10 years.
Guaranteed minimum rates: Once the initial guarantee period expires, the rate is adjusted based on a specific formula or the prevailing yield earned in the insurer’s investment account. As a measure of protection against declining interest rates, fixed annuity contracts include a minimum rate guarantee.
Tax-deferred growth: As a tax-qualified vehicle, fixed annuities offer tax-deferred accumulation of earnings. For people in the higher tax brackets, this can make a significant difference in the amount accumulated over time. When the earnings are withdrawn or taken as income, they are taxed as ordinary income. The amount paid in taxes is determined at that point by the annuitant's current tax bracket.
Withdrawals: Fixed annuities allow for one annual withdrawal per year up to 10 percent of the account value. During the surrender period, which can run from one to 15 years from the start of the contract, withdrawals over 10 percent are subject to a surrender charge. The surrender charge declines each year until it reaches zero and withdrawals are free from this charge. Withdrawals made prior to age 59 ½ may be subject to a tax penalty of 10 percent in addition to ordinary income taxes.
Guaranteed income payments: Fixed annuities may be converted to an immediate annuity at any time to generate a guaranteed income payout for a specified period of time or for the life of the annuitant.
Safety of principal: The life insurance company guarantees the capital invested in a fixed annuity. For that reason, investors should only consider investing with life insurance companies rated A or better for their financial strength.
Drawbacks to an Annuity
No investment is perfect, and this is also true of annuities. Any annuity requires you to give money to an insurance company for a period of time, during which you will not have access to it. Annuities can also carry hefty fees that eat into returns. Finally, annuities are not protected by any national insurance program. If the insurance company offering the annuity goes out of business, the annuitant may never recover the money.