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

A fixed deferred annuity is a financial contract designed to help individuals save for retirement by offering a guaranteed interest rate and tax-deferred growth. It accumulates funds over time, converting them into a reliable income stream for future needs, providing financial security.

Core Characteristics

A fixed deferred annuity distinguishes itself through its guaranteed interest rate, which is set by the issuing insurance company for a specified period. This provides predictability and protects the principal from market volatility.

The “deferred” aspect signifies an accumulation period where money grows without immediate taxation on earnings. This tax-deferred growth allows interest to compound more efficiently, as taxes are postponed until withdrawals begin. This can be beneficial for those in higher tax brackets during their working years.

Annuity guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company. After an initial guaranteed interest rate period, the insurer resets the rate, but it cannot fall below a minimum stated in the contract. This contractual guarantee makes the company’s solvency an important consideration.

Annuity Phases

A fixed deferred annuity progresses through two distinct stages: the accumulation phase and the payout phase. During accumulation, funds are contributed via a single lump-sum payment or flexible premiums. The money grows through credited interest, compounding on a tax-deferred basis, meaning earnings are not taxed until withdrawn.

This tax deferral allows the annuity’s value to grow potentially faster than a taxable account, as reinvested earnings are not reduced by annual taxes. During this period, the annuity holder typically does not receive income payments, as the goal is to build the contract’s value. This phase often lasts until the annuitant reaches retirement age.

The transition to the payout phase, also known as annuitization, occurs when the annuity holder converts the accumulated value into a stream of regular income payments. This conversion can be initiated at a future date, often at retirement. Once annuitization begins, the process typically becomes irreversible.

Income Payout Options

Upon reaching the payout stage, annuity holders have several options for accessing their accumulated funds.

Lump-Sum Withdrawal

A lump-sum withdrawal takes the entire accumulated value as a single payment. The portion of the withdrawal representing earnings is subject to ordinary income tax in the year of withdrawal. Additionally, withdrawals made before age 59½ may incur a 10% federal tax penalty, along with regular income taxes.

Systematic Withdrawals

Systematic withdrawals involve taking regular, pre-determined amounts from the accumulated value. These withdrawals can be scheduled monthly, quarterly, or annually and continue until funds are depleted or the annuity holder chooses to stop. This method provides a consistent income stream without fully converting the annuity into an irreversible annuitization plan, offering more control.

Alternatively, the annuity holder can choose to annuitize, converting the accumulated value into a guaranteed stream of periodic payments. Several annuitization options exist, tailored to different income needs and life expectancies.

Life Only

A “Life Only” option provides payments for the annuitant’s lifetime, ceasing upon their death, and typically offers the highest individual payment amounts. However, no further payments are made to beneficiaries after the annuitant’s passing.

Life with Period Certain

The “Life with Period Certain” option ensures payments for the annuitant’s lifetime, but also guarantees them for a minimum number of years, 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

A “Joint and Survivor” annuity provides payments for the lifetimes of two individuals, commonly spouses, with payments continuing to the surviving individual after the first death. Payments under this option are usually smaller than a single life annuity because they are designed to last for a potentially longer duration.

Fixed Period

Finally, a “Fixed Period” option, also known as period certain only, makes payments for a specific, pre-determined number of years, regardless of the annuitant’s lifespan. If the annuitant dies before the period ends, the remaining payments are made to a beneficiary.