How Does a Fixed Annuity Work?
Learn how a fixed annuity provides predictable, guaranteed income for your financial future. Understand its structure, growth, and payout process.
A fixed annuity is a contract with an insurance company, offering a secure path to guaranteed income. It provides predictable payments, often used for long-term financial planning. Individuals contribute funds and receive a stream of payments that can last for a specified period or a lifetime.
Understanding Fixed Annuities
A fixed annuity is a contract between an individual, the owner, and an insurance company. It ensures a guaranteed interest rate on contributions, leading to predictable future payments. Unlike variable annuities, which involve investment risk and fluctuating returns, fixed annuities offer a stable interest rate.
Key parties in an annuity contract include the owner, who purchases the contract and makes decisions. The annuitant is the person whose life expectancy determines payment amounts and duration. A beneficiary receives any remaining benefits upon the annuitant’s death. The insurance company issues the contract and guarantees payments.
How Fixed Annuities Generate Value
A fixed annuity’s value grows during its accumulation phase through a guaranteed interest rate. This rate is established by the insurance company and remains constant for a specific duration. After this initial guaranteed period, the interest rate may be reset, but it will not fall below a minimum rate specified in the contract.
Interest earned within the annuity compounds over time, allowing the principal to grow without immediate taxation. This tax-deferred growth means earnings are not taxed until they are withdrawn. Premiums can be paid into the annuity as a single lump sum or through flexible payments. This accumulation strategy provides a structured way to build savings with a predictable rate of return.
Receiving Payments from a Fixed Annuity
Once a fixed annuity reaches the payout phase, known as annuitization, the accumulated value is converted into a stream of guaranteed income payments. The timing of these payments depends on the type of fixed annuity. Immediate annuities begin payments shortly after purchase, typically within one year, often funded by a single lump sum. In contrast, deferred annuities allow the accumulated value to grow over time, with payments commencing at a future date chosen by the owner.
Annuitization involves selecting from various payout options that determine how income is received. A “life only” option provides payments for the annuitant’s lifetime, but payments cease upon their death without a death benefit to beneficiaries. A “life with a period certain” option guarantees payments for the annuitant’s life or for a specified period, such as 10 or 20 years, whichever is longer; if the annuitant dies before the period ends, payments continue to a beneficiary for the remainder of the period. A “joint and survivor” option provides payments for the lives of two individuals, continuing to the survivor after the first annuitant’s death. Some annuities also permit partial withdrawals without full annuitization, though these may be subject to fees or penalties.
Taxation of Fixed Annuities
Fixed annuities offer the benefit of tax-deferred growth, meaning that earnings accumulate without being subject to income tax until they are withdrawn. This deferral applies to interest, dividends, and capital gains within the annuity. However, when withdrawals are made from a non-qualified annuity (funded with after-tax money), they are generally subject to the “last-in, first-out” (LIFO) rule for tax purposes. This rule dictates that earnings are considered to be withdrawn first and are taxed as ordinary income, before the tax-free return of the principal.
When annuity payments begin through annuitization from a non-qualified contract, a portion of each payment is considered a tax-free return of the principal, while the earnings portion is taxable. This division is determined by an “exclusion ratio,” which is calculated by dividing the investment in the contract by the expected total return. The IRS provides guidelines and actuarial tables to help determine this ratio. For annuities funded with pre-tax money, such as through a 401(k) or IRA (qualified annuities), the entire amount of withdrawals or payments is typically taxed as ordinary income. Death benefits paid to beneficiaries are generally taxable on the earnings portion, with the tax treatment varying based on whether the annuity was qualified or non-qualified, and whether the beneficiary is a spouse or non-spouse.