What Is a Fixed Annuity?

What Is a Fixed Annuity?

Let me explain what a fixed annuity is—it's an insurance contract where you get a promised guaranteed interest rate on the money you put in. Compare that to a variable annuity, which pays interest that changes based on how an investment portfolio you choose performs.

You typically use fixed annuities to set up a steady income stream once you're retired.

Key Takeaways

Fixed annuities are insurance contracts that give you a guaranteed interest rate based on your deposits. Variable annuities, on the other hand, vary their rates depending on the investments you pick. Earnings in a fixed annuity grow tax-deferred until you start taking income. Remember, annuities aren't ideal for everyone because of their high fees.

How a Fixed Annuity Works

You can purchase a fixed annuity with a single lump sum or through ongoing payments. The insurance company then guarantees a specific interest rate during what's called the accumulation phase.

When you, as the annuitant, decide to start getting regular income, the company figures out your payments based on the account balance, your age, how long the payments will last, and other details. This kicks off the payout phase, which could run for a set number of years or your entire life, depending on what you choose. You can even set up death benefits for a surviving spouse.

In the accumulation phase, your account grows without taxes hitting it right away. Then you annuitize the contract, and the payments you receive are taxed based on an exclusion ratio—that's the part from investment earnings, not your original after-tax contributions, which are excluded from taxes.

Fixed annuities come as immediate ones that pay out right away or deferred ones that start later.

Benefits of a Fixed Annuity

You can gain from fixed annuities in several ways. First, they offer predictable income—the rates come from the yields on the insurer's portfolio, mostly high-quality bonds, and the company has to pay the promised rate, unlike variable annuities where you bear the investment risk.

Once the initial guarantee ends, the insurer might adjust the rate based on a formula or their portfolio yields, but there's usually a minimum rate to protect against falling interest rates.

Growth is tax-deferred since it's a qualified vehicle, so you pay taxes only on withdrawals or income, which can really boost the account over time, especially if you're in a high tax bracket—similar to IRAs or 401(k)s.

You'll get guaranteed income for a set period or life, and possibly for beneficiaries after you pass. Plus, the principal is relatively safe, as the insurer handles the security and promises, though annuities aren't federally insured, so stick to highly rated companies.

Important Note on Annuities

Annuities often come with high fees, so you should shop around and look at other investments.

Fixed Annuities vs. Variable Annuities

Both fixed and variable annuities are tax-advantaged insurance products for retirement income that can last your life or beyond, but they differ. With a fixed annuity, you get a guaranteed set payment no matter the market, making it conservative with fixed interest for predictable income—great if you avoid risk.

A variable annuity ties to market performance, so payments fluctuate based on your investment choices like mutual funds, offering higher potential returns but with more volatility and fees. Your choice depends on risk tolerance, time horizon, and goals.

Criticisms of Fixed Annuities

The big drawback is high fees, like surrender charges—if you withdraw more than 10% during the surrender period, which can last up to 15 years, you face hefty penalties. If you're under 59½, add a 10% IRS penalty plus income taxes.

They're illiquid too, usually allowing just one withdrawal per year up to 10% of value. So, use them for long-term investing and steady income, not everyday spending or big one-time buys. For those, consider high-yield savings, living trusts, or 529 plans instead.

How Does an Annuity Work?

An annuity has an accumulation phase where you pay in a lump sum or periodically, and a payout phase where you get distributions, often quarterly or annually.

What Is the Difference Between a Retirement Plan and an Annuity?

An annuity is an insurance company contract, while retirement plans come from banks or financial firms. Retirement plans include defined-contribution like 401(k)s and defined-benefit like pensions. The accumulation phase of an annuity mirrors a defined-contribution plan pre-retirement, and the payout phase is like a defined-benefit in retirement. Both can defer taxes until withdrawal.

Is an Annuity a Good Idea?

It depends on your financial situation and goals. With their high fees, consider maxing out a 401(k) first—the IRS adjusts limits yearly, and if you're 50+, you get catch-up contributions.

The Bottom Line

Annuities are complex insurance contracts for supporting you in retirement, but they have higher fees than many investments. Make sure you understand all fees before committing, and shop around since terms vary. Take your time weighing pros and cons.