What Is a 5-Year Fixed Annuity and How Does It Work?

Defining a Fixed Annuity

An annuity is a contractual agreement between an individual and an insurance company, providing a steady stream of payments for retirement planning. Individuals pay premiums, either as a lump sum or over time. The company then disburses future payments, allowing funds to accumulate for a later income stream.

A fixed annuity offers a guaranteed interest rate on the principal for a specified period, providing predictability and stability. Unlike market-tied investments, its interest does not change with stock market performance. This protects the principal from downturns, as the insurance company guarantees the return of principal and the stated interest rate.

The guaranteed interest rate distinguishes fixed annuities from other types. Variable annuities involve investments that fluctuate with market conditions, and indexed annuities link returns to a market index. A fixed annuity provides a clear, predetermined rate of return, offering a conservative approach to savings. This certainty allows individuals to forecast its future value.

During the accumulation phase, funds grow at the guaranteed rate, compounding over time. While fixed annuities can be converted into income payments (annuitization), a shorter term, like five years, typically focuses on principal growth. Invested capital can increase, benefiting from guaranteed interest before distributions begin.

Understanding the 5-Year Term

The 5-year duration signifies the period for the initial guaranteed interest rate and specific contractual terms, such as surrender charges. During this term, the annuity holder benefits from the predetermined rate of return on their accumulated funds. This fixed period provides a clear horizon for principal growth.

Surrender charges are fees imposed if the annuity holder withdraws more than a specified amount or surrenders the contract before the term ends. These charges compensate the insurance company for expenses in issuing the contract. Typically, surrender charges are highest in the first year and gradually decline over the 5-year period, reaching zero at term end. For example, a common schedule might be 7% in the first year, declining by 1% annually.

Most 5-year fixed annuities include provisions for penalty-free withdrawals. These allowances typically permit the annuity holder to withdraw a percentage of the accumulated value, often around 10%, annually without incurring surrender charges. This offers liquidity, allowing access to a portion of funds for unexpected needs while maintaining the core investment. However, withdrawals exceeding this allowance are subject to applicable surrender charges.

Upon the 5-year term’s conclusion, the annuity contract matures. The annuity holder has several options. They can renew the annuity for another fixed term, often at a new prevailing interest rate, or annuitize the contract, converting the accumulated value into periodic income payments. Other choices include a lump-sum withdrawal or transferring funds to another annuity without surrender charges.

Taxation of Fixed Annuities

Fixed annuity earnings benefit from tax-deferred growth, meaning taxes on interest are not due until funds are withdrawn. This allows earnings to compound without annual taxation, potentially leading to greater accumulation compared to a taxable account. Principal contributions are considered after-tax money if the annuity is non-qualified, while earnings are tax-deferred.

When withdrawals are made from a non-qualified annuity, the IRS generally applies a “last-in, first-out” (LIFO) rule for taxation. This rule dictates that the earnings portion of any withdrawal is first and is subject to taxation as ordinary income. Only after all earnings are withdrawn does the return of the original, non-taxable principal begin. This means early withdrawals are often fully taxable until the earnings portion is depleted.

If withdrawals are made from a fixed annuity before age 59½, the taxable portion may be subject to an additional 10% federal income tax penalty. This penalty is imposed in addition to ordinary income tax due on the earnings. Exceptions exist for disability or as part of a series of substantially equal periodic payments.

An annuity’s tax treatment depends on whether it is a qualified or non-qualified contract. A qualified annuity is funded with pre-tax dollars, often as part of a retirement plan like a 401(k) or IRA, meaning both contributions and earnings are taxed upon withdrawal. A non-qualified annuity is funded with after-tax dollars, so only the earnings are subject to taxation. Consult a qualified tax professional for personalized guidance.

Acquiring a 5-Year Fixed Annuity

Obtaining a 5-year fixed annuity begins with gathering essential personal and financial information. This includes your full legal name, date of birth, Social Security number, contact information, and details for designated beneficiaries (names, relationship, Social Security numbers).

The application process involves working with a licensed insurance agent or financial advisor specializing in annuity products. They guide you through completing the application form, which details your investment amount, chosen annuity product, and beneficiary designations. This form serves as the official request to the insurance company to issue the contract.

Funding the annuity requires providing details about the source of your premium payment. This could involve bank account information for an electronic funds transfer, submitting a check, or initiating a direct rollover or transfer from an existing retirement account, such as an IRA or 401(k). Verification of the source of funds may be required for compliance.

After the application and funding details are submitted, the insurance company reviews the application for completeness and accuracy. This review typically lasts a few business days to a few weeks. Once approved, the insurance company issues the annuity contract, outlining terms, conditions, and guarantees.