What Is a Fixed Annuity and How Does It Work?

A fixed annuity is a financial contract offered by an insurance company, designed to provide a predictable stream of income, often for retirement. It functions as a conservative financial tool, allowing individuals to accumulate savings with a guaranteed interest rate and later convert those savings into regular payments. This product appeals to those seeking stability and a defined income floor for their financial future. Fixed annuities play a role in diversifying a financial portfolio, offering a level of certainty not typically found in market-sensitive investments.

Understanding Fixed Annuities

A fixed annuity is a contract between an individual and an insurance company. The contract begins when an individual pays a premium, which can be a single lump sum or a series of periodic payments over time.

Following the premium payment, the annuity enters its accumulation phase. During this period, the money deposited grows at an interest rate guaranteed by the insurance company. This growth occurs on a tax-deferred basis, meaning that earnings are not subject to income tax until they are withdrawn or distributed.

Once the accumulation phase concludes, or at a chosen future date, the annuity transitions into its annuitization or payout phase. In this stage, the accumulated value is converted into a series of regular, guaranteed payments to the contract holder. These payments can be structured to last for a set period or, commonly, for the remainder of the annuitant’s life. The payout phase provides a reliable income stream, fulfilling the primary purpose of many annuities.

Key Features of Fixed Annuities

A fixed annuity’s primary feature is its guaranteed interest rate. The insurance company declares a specific rate for the accumulated funds, often for a predetermined period such as one, three, or five years. This rate provides predictability for the growth of the principal, standing apart from investment vehicles tied to market fluctuations. Even after an initial guarantee period, the contract specifies a minimum interest rate, ensuring ongoing growth.

Fixed annuities also provide principal protection. The initial investment and any credited interest are safeguarded from market downturns. This means the annuity’s value will not decrease due to adverse market performance, offering a secure environment for savings.

Another key feature is the predictable income stream. Once annuitized, payment amounts are fixed and known in advance. This certainty allows individuals to plan their future expenses with confidence, knowing the exact amount of income they will receive.

Types and Payout Options

Fixed annuities are broadly categorized into immediate and deferred types. An immediate fixed annuity starts providing income payments shortly after the premium is paid, typically within one year. This option is often chosen by individuals already in retirement who need an immediate source of guaranteed income.

Conversely, a deferred fixed annuity includes a significant accumulation phase before payments commence. This allows invested funds to grow tax-deferred, making it a common choice for those planning for retirement far in advance.

Fixed annuities offer various payout options, known as annuitization options. The selection of a payout option directly influences the amount of each payment, with options covering longer durations or multiple lives generally resulting in smaller individual payments.

• Life Only: Payments are made for the annuitant’s lifetime, ceasing upon their death.
• Period Certain: Guarantees payments for a specific number of years. If the annuitant passes away before the period ends, the remaining payments typically go to a designated beneficiary.
• Life with Period Certain: Combines both features, providing payments for life but guaranteeing them for a minimum number of years.
• Joint and Survivor: Ensures payments continue for two lives, often spouses, until the death of the second annuitant.

Taxation and Guarantees

The tax treatment of fixed annuities differs between the accumulation and payout phases. During the accumulation phase, earnings within a non-qualified annuity grow on a tax-deferred basis, meaning taxes are not due until funds are withdrawn. For withdrawals made before annuitization, the Internal Revenue Service (IRS) generally applies a “last-in, first-out” (LIFO) rule, taxing earnings first. A federal penalty of 10% may apply to taxable withdrawals made before age 59½, in addition to ordinary income taxes. However, certain exceptions exist, such as withdrawals due to death or disability.

Once the annuity enters the payout phase, each payment received is typically comprised of two parts: a return of principal, which is tax-free, and a portion representing taxable interest. This is determined by an “exclusion ratio,” which is calculated based on the investment in the contract and the expected return, often over the annuitant’s life expectancy. Once the entire principal has been returned tax-free, subsequent payments become fully taxable as ordinary income.

Fixed annuities are backed by the financial strength of the issuing insurance company. State guarantee associations exist in all states, providing a safety net for contract holders in the event that an insurance company becomes insolvent. Coverage limits vary by state, but most states provide up to $250,000 in present value of annuity benefits per contract holder. Some states may offer higher limits or an overall cap for an individual with multiple policies.