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

A fixed income annuity is a contractual agreement between an individual and an insurance company. It provides a guaranteed stream of income, often used for retirement planning. This financial product converts a lump sum or series of payments into predictable distributions over a specified period or for a lifetime.

Core Structure and Guarantees

A defining characteristic of a fixed income annuity is its guaranteed interest rate, set by the insurance company for a specific duration. This rate ensures predictable growth of the principal, as it remains unaffected by fluctuations in market performance.

Funds are contributed to the annuity either through a single lump-sum payment or a series of regular premiums, which then accumulate value over time with the applied guaranteed interest. This accumulated value can then be converted into a steady flow of payments to the annuitant at a future date.

Earnings within a fixed annuity grow on a tax-deferred basis, meaning taxes are not due until withdrawals or income payments begin. However, if funds are withdrawn prematurely, typically before age 59½, they may be subject to a 10% federal income tax penalty in addition to ordinary income taxes on the earnings portion.

Most fixed annuities include a surrender charge period, which is a specified timeframe during which withdrawals exceeding a certain allowance can incur a penalty. This period commonly ranges from 3 to 10 years. Many contracts permit a penalty-free withdrawal of a portion of the account value, often around 10% annually. The security and guarantees of a fixed annuity are ultimately backed by the financial strength and claims-paying ability of the issuing insurance company.

Income Payout Options

Once a fixed income annuity reaches the payout phase, the accumulated value is converted into a series of periodic income payments through a process known as annuitization. The choice of payout option significantly influences the amount and duration of these payments.

One common payout choice is the “Life Only” option, which provides the highest possible periodic payment to the annuitant. Under this arrangement, payments continue for the annuitant’s entire lifetime but cease upon their death, with no remaining value passed to beneficiaries. This option carries the risk of forfeiture if the annuitant dies shortly after payments begin.

Alternatively, the “Life with Period Certain” option guarantees payments for the annuitant’s life, but also for a minimum specified period. If the annuitant passes away before the guaranteed period ends, their designated beneficiaries receive the remaining payments for the remainder of that period. Should the annuitant live beyond the period certain, payments continue for their lifetime.

A “Joint and Survivor” payout option is designed for two individuals, typically spouses. Payments continue for the lifetime of both the primary annuitant and a second designated person. Upon the death of the primary annuitant, payments continue to the survivor, often at a reduced percentage of the original amount, providing income security for the surviving individual.

The “Fixed Period” option provides payments for a predetermined number of years, irrespective of the annuitant’s lifespan. If the annuitant dies before the fixed period concludes, the remaining payments are typically made to the named beneficiaries. Each of these payout choices impacts the size of the individual payments, with options offering greater guarantees or longer potential durations generally resulting in smaller periodic amounts.

Variations in Fixed Annuities

Fixed annuities come in different structural forms that determine when contributions are made and when income payments commence. Immediate fixed annuities, also known as Single Premium Immediate Annuities (SPIAs), are funded with a single lump-sum premium, and income payments typically begin within one year of purchase. These are suitable for individuals who need to convert a sum of money into immediate, predictable income.

In contrast, deferred fixed annuities include an accumulation phase during which premiums grow with interest before income payments begin at a future date chosen by the annuitant. Deferred annuities can be further categorized based on their premium payment structure.

A Single Premium Deferred Annuity (SPDA) is funded with one lump-sum payment at the contract’s inception, and the funds accumulate over time before the payout phase starts. This option is often chosen by individuals with a significant amount of capital they wish to grow tax-deferred for future income. Conversely, a Flexible Premium Deferred Annuity (FPDA) allows for multiple payments over time, providing more flexibility for contributions during the accumulation phase.

Many fixed annuities also incorporate death benefit features, which provide financial protection for beneficiaries. A standard death benefit pays the remaining contract value to designated beneficiaries upon the annuitant’s death, bypassing the probate process if properly named. Some contracts may offer a “return of premium” death benefit, ensuring beneficiaries receive at least the total premiums paid, minus any withdrawals, even if the account value has declined.

The tax treatment of death benefits varies; for non-qualified annuities, beneficiaries are taxed only on the earnings portion, while for qualified annuities, the entire death benefit may be taxable as ordinary income to the beneficiary.