What Are Fixed Annuities and How Do They Work?

Annuities are financial contracts, typically with an insurance company, designed to provide a steady income stream, often during retirement. These arrangements involve an individual making payments, known as premiums, to the insurer. In exchange, the insurance company agrees to provide regular disbursements, either immediately or at a future date. Annuities are a tool for long-term financial planning, especially for consistent income in retirement.

Defining Fixed Annuities

A fixed annuity is a specific type of insurance contract characterized by its guaranteed interest rate and principal protection. The term “fixed” refers to the predictability of its growth. The insurance company guarantees a set interest rate for a specified period, which can be several years or for the life of the contract. After an initial guaranteed period, typically five years, the insurer may reset the interest rate annually, but it cannot fall below a guaranteed minimum rate stated in the contract.

The principal within a fixed annuity is protected by the issuing insurance company. This means the principal will not decrease due to market fluctuations, offering a conservative option for individuals with a lower risk tolerance. This structure provides a predictable income stream, distinguishing fixed annuities from other types of annuities where returns may vary with market performance.

Funds can be contributed either as a lump sum or through a series of payments over time. This period, during which the annuity’s value grows through credited interest before income payments begin, is known as the accumulation phase.

Types of Fixed Annuities

Fixed annuities are primarily categorized by when their income payments begin. This distinction helps individuals select a product that aligns with their immediate or future income needs.

Immediate fixed annuities, often referred to as Single Premium Immediate Annuities (SPIAs), begin providing income payments within one year of purchase. These are typically funded with a single lump sum and are suited for individuals who require an immediate and predictable income stream, such as those already in retirement. The income payments are determined at the time of purchase and remain consistent.

Deferred fixed annuities, conversely, delay income payments until a future date, usually at retirement. This type of annuity has two distinct phases: the accumulation phase and the payout phase. During the accumulation phase, the invested money grows on a tax-deferred basis, meaning earnings are not taxed until they are withdrawn.

A common variation of a deferred fixed annuity is the Multi-Year Guaranteed Annuity (MYGA). MYGAs offer a guaranteed fixed interest rate for a specific term, commonly ranging from three to ten years. Unlike traditional fixed annuities where the rate might be reset annually after an initial period, a MYGA’s rate is locked in for the entire chosen term, providing predictable growth and stability.

Understanding Payout Options

Once the accumulation phase is complete for a deferred annuity, or immediately for an immediate annuity, individuals can begin receiving funds through various payout options. These options dictate how the accumulated value is converted into a stream of income or withdrawn.

One common method is annuitization, which converts the annuity’s accumulated value into a guaranteed stream of periodic payments. Several annuitization options exist. A “Life Only” annuity provides payments for the annuitant’s entire life, ceasing upon their death. This option typically offers the highest individual payment amounts but leaves no remaining value for beneficiaries.

Another option is “Life with Period Certain,” which guarantees payments for the annuitant’s life, but also for a specified minimum period, such as 10 or 20 years. If the annuitant dies before the period certain ends, payments continue to a named beneficiary for the remainder of that guaranteed period. “Joint and Survivor” annuities are designed to provide payments for the lives of two individuals, often spouses. If one annuitant dies, the surviving annuitant continues to receive payments, which may be the full amount or a reduced percentage, such as 50% or 75% of the original payment.

Beyond annuitization, individuals may also opt for withdrawals. A “Lump-Sum Withdrawal” allows the entire accumulated value to be taken out at once. However, this option may incur surrender charges, which are fees imposed by the insurance company for early withdrawals, especially if taken before the contract’s specified surrender period ends. “Partial Withdrawals” enable individuals to take out portions of the annuity’s value as needed, often up to a certain percentage, such as 10% of the account value, per year without incurring surrender charges.

Tax Considerations for Fixed Annuities

Understanding the tax implications of fixed annuities is important, as earnings and withdrawals are subject to specific Internal Revenue Service (IRS) rules. A primary benefit of annuities is their tax-deferred growth. Earnings within the annuity accumulate without being subject to current income taxes until funds are withdrawn. This tax deferral allows the money to potentially grow faster through compounding, as taxes are not subtracted annually.

The taxation of withdrawals depends on how the annuity was funded. For non-qualified annuities, which are purchased with after-tax dollars, withdrawals are generally taxed under the “last-in, first-out” (LIFO) rule. This means that earnings are considered to be withdrawn first and are taxed as ordinary income. Once all the earnings have been withdrawn, subsequent distributions of the original principal are returned tax-free.

If a fixed annuity is held within a qualified retirement account, such as an Individual Retirement Account (IRA) or 401(k), it is considered a qualified annuity. In this case, all distributions, including both contributions and earnings, are typically taxed as ordinary income upon withdrawal, similar to other distributions from these tax-advantaged retirement plans. The tax deferral benefit in qualified plans is provided by the plan itself, not the annuity.

Withdrawals made before age 59½ from either non-qualified or qualified annuities may be subject to an additional 10% IRS early withdrawal penalty on the taxable portion, unless a specific exception applies. Common exceptions include withdrawals due to death or disability, or those made as part of a series of substantially equal periodic payments.

For annuitized payments from non-qualified annuities, a portion of each payment is considered a tax-free return of principal, while the earnings portion is taxable as ordinary income. This is determined by an “exclusion ratio,” which is calculated by dividing the initial investment (cost basis) by the expected total return from the annuity based on life expectancy. The exclusion ratio determines the percentage of each payment that is excluded from taxation.