What Is a Fixed Annuity Investment and How Does It Work?

Fixed annuities are financial contracts with an insurance company, designed to provide a steady income stream, often for retirement. They involve an initial payment or series of payments in exchange for future regular disbursements, offering predictable returns and income.

Understanding Fixed Annuity Structure and Mechanics

A fixed annuity is a contract between an individual and an insurance company that offers principal protection and a guaranteed, predetermined interest rate for a period. This makes it similar to a bank certificate of deposit, providing a predictable path for asset growth. The insurance company guarantees the interest rate, typically for one to five years or longer. After this initial period, the rate may reset but will not fall below a guaranteed minimum specified in the contract. The financial strength and claims-paying ability of the issuing insurance company back these guarantees.

The “accumulation phase” is when premiums are paid into the annuity and the contract value grows. During this phase, funds earn interest at the guaranteed rate, and these earnings typically grow tax-deferred. The insurance company invests premiums to generate returns, contributing to the contract’s growth.

Fixed annuities can be funded with a single premium or multiple premiums. A single premium fixed annuity is purchased with one lump-sum payment, often from rolling over retirement funds or asset sales. A multiple premium fixed annuity allows for a series of payments over time, enabling regular contributions during the accumulation phase. Each premium payment typically begins earning interest from the time it is received by the insurer.

Interest crediting methods for fixed annuities can vary. Some contracts use a “new money” method, where different interest rates may apply based on when each premium payment is received. Other contracts might use a “portfolio” method, where all fixed annuity contracts are credited the same interest rate from a combined investment portfolio. A “tiered” method might offer different rates based on the annuity’s value or adjust the rate if the contract is surrendered instead of annuitized. The core feature remains the guaranteed interest rate, offering stability compared to market-tied investments.

Fixed Annuity Payouts

The transition from the accumulation phase to receiving income payments is known as the “payout” or “annuitization” phase. Once funds have accumulated, the contract holder can choose how to receive the money. One option is a lump sum withdrawal, where the entire accumulated value is taken at once. This option can have significant tax implications as all taxable earnings become immediately due.

Alternatively, the contract can be annuitized, converting the accumulated value into a series of regular payments. The amount of these payments is determined by factors such as the accumulated value, the annuitant’s age, the chosen payout option, and prevailing interest rates. Several annuitization options are available to suit different income needs and preferences:
Life Only: Provides payments for the annuitant’s entire life, ceasing upon death. This offers income security for life, but payments stop even if the total received is less than the initial investment.
Life with Period Certain: Provides payments for the annuitant’s life, but also guarantees payments for a specified minimum period, such as 10 or 20 years. If the annuitant dies before the guaranteed period ends, payments continue to a designated beneficiary for the remainder of that period.
Joint and Survivor: Ensures payments continue for the lives of two individuals, typically a spouse, with payments continuing to the surviving individual after the first passes away. This provides financial security for both partners.
Specific Period (Fixed Period): Provides payments for a set number of years, regardless of the annuitant’s lifespan. If the annuitant dies before the period ends, payments continue to the beneficiary for the remaining duration.

Fixed annuities also differ by payment timing:
Immediate Fixed Annuities: Begin income payments soon after purchase, typically within one year. These are often chosen by those who have already accumulated retirement savings and seek immediate income.
Deferred Fixed Annuities: Have an accumulation phase where funds grow before payments begin at a future, specified date. This allows for continued growth before income is needed, usually in retirement.

Taxation of Fixed Annuities

One of the significant features of fixed annuities is their tax treatment during the accumulation phase. Earnings within a fixed annuity grow tax-deferred, meaning that taxes on the interest and investment gains are not paid until funds are withdrawn. This allows the earnings to compound over time without annual taxation, potentially leading to greater growth.
Non-qualified annuities: Funded with after-tax dollars. Only the earnings portion is taxed as ordinary income upon withdrawal; the principal is returned tax-free.
Qualified annuities: Funded with pre-tax dollars (e.g., through IRAs or 401(k)s). The entire withdrawal amount is generally taxed as ordinary income.

Withdrawals made before age 59½ are generally subject to an additional 10% federal income tax penalty on the taxable portion of the withdrawal, in addition to regular income taxes. This penalty is designed to discourage using annuities as short-term savings vehicles rather than for retirement income. However, certain exceptions exist that may allow withdrawals before age 59½ without incurring this penalty, such as distributions due to the annuitant’s total and permanent disability or payments made to a beneficiary upon the annuitant’s death.

Upon the death of the annuitant, the tax treatment for beneficiaries depends on whether it was a qualified or non-qualified annuity and how the death benefit is received. For non-qualified annuities, beneficiaries typically pay taxes only on the earnings portion of the death benefit. If the annuity was qualified, the entire death benefit is generally taxable to the beneficiary as ordinary income. Beneficiaries often have options for receiving the death benefit, including a lump sum, which can result in a higher tax burden in that year, or receiving payments over time, which can spread out the tax liability. Spouses, in particular, may have the option to continue the annuity in their own name, potentially deferring taxation.