What Is a Fixed Annuity and How Does It Work?

A fixed annuity is a contract between an individual and an insurance company, designed to provide a guaranteed stream of income, often used for retirement planning. Premiums are paid in exchange for future payments, with the insurance company assuming the investment risk. This arrangement offers a predictable financial return, distinguishing it from investment vehicles whose values fluctuate with market performance.

Core Mechanics of Fixed Annuities

An individual typically funds a fixed annuity by paying premiums, which can be a single lump sum or a series of payments made over time. In return, the insurance company guarantees a specific interest rate on these contributions for a defined period. This guaranteed interest rate ensures the money grows at a known pace, regardless of market fluctuations.

A core component of a fixed annuity is the protection of the principal amount invested. The insurance company guarantees both the initial principal and a minimum interest rate, meaning the investor will not lose their original contributions due to market downturns. While the declared interest rate might be reset periodically, it will never fall below the minimum rate specified in the contract.

Accumulation and Payout Phases

A fixed annuity’s lifecycle unfolds in two distinct stages: the accumulation phase and the payout phase. During the accumulation phase, the annuity holder makes premium payments, and the money within the contract grows through credited interest. During this time, earnings accumulate on a tax-deferred basis, meaning taxes on the interest are postponed until withdrawals are made. This deferral allows the earnings to compound more efficiently, as the growth is not reduced by annual taxation.

The payout phase, also known as the annuitization phase, begins when the annuity owner converts the accumulated value into a stream of guaranteed income payments. This provides a predictable income stream, which can last for a specified period or for the rest of the annuitant’s life. Common payout options include payments for a single life, joint and survivor options, or payments for a period certain. Once annuitized, the payment amounts are typically fixed and guaranteed.

Common Fixed Annuity Structures

Fixed annuities come in various structural forms.

Deferred Fixed Annuities

Deferred fixed annuities are structured for long-term growth, with income payments commencing at a future date, often during retirement. These annuities allow for tax-deferred growth over an extended period, making them suitable for individuals who do not require immediate income. Payments can be made as a lump sum or through a series of contributions during the accumulation period.

Immediate Fixed Annuities (SPIAs)

Immediate fixed annuities, also known as Single Premium Immediate Annuities (SPIAs), are designed for individuals who need income payments to begin almost immediately after purchasing the contract. These are typically funded with a single, lump-sum premium payment. SPIAs convert a portion of savings into a guaranteed income stream, often starting within one year of purchase.

Multi-Year Guaranteed Annuities (MYGAs)

MYGAs are a popular type of deferred fixed annuity. A MYGA offers a guaranteed interest rate for a specific number of years, commonly ranging from three to ten years. This structure provides predictable returns over a defined period, similar to a certificate of deposit but with the added benefit of tax-deferred growth. At the end of the guaranteed period, the contract holder may renew the annuity at a new rate, transfer the funds, or begin receiving payments.

Tax Treatment of Fixed Annuities

Earnings within a fixed annuity grow on a tax-deferred basis, meaning taxes on the accumulated interest are postponed until funds are withdrawn or payments begin. This deferral allows the money to compound without being reduced by annual income taxes.

When withdrawals are made from a non-qualified annuity (funded with after-tax dollars), the Internal Revenue Service (IRS) generally applies the “last-in, first-out” (LIFO) rule. This means earnings are considered withdrawn first and taxed as ordinary income, while the return of principal is tax-free. For withdrawals made before age 59½, the taxable portion may also be subject to an additional 10% federal tax penalty, as outlined in Section 72.

Once an annuity is annuitized, each payment is typically composed of a tax-free return of principal and a taxable portion representing the earnings. Death benefits from annuities are generally taxable to beneficiaries on the earnings portion, with qualified annuities being fully taxable as ordinary income and non-qualified annuities taxing only the gains.