What Is a Fixed Term Annuity & How Does It Work?

Annuities are financial contracts designed to provide a steady income stream, often utilized in retirement planning. An individual makes a payment, or a series of payments, to an insurance company. In return, the insurance company commits to providing regular disbursements, either immediately or at a future date. This offers a structured approach to managing finances, particularly for those seeking predictable income flow during their post-employment years.

Defining a Fixed Term Annuity

A fixed term annuity is a financial product offering a guaranteed income for a specific, predetermined period. It functions as a contract between an individual, known as the annuitant, and an insurance company, the insurer. The annuitant provides funds to the insurer, and in exchange, the insurer commits to making regular, fixed payments for a set duration. This structure provides predictability, as both the payment amount and the length of the payment period are established at the contract’s inception.

The purpose of a fixed term annuity is to provide a consistent income stream for a defined number of years, typically ranging from three to 25 years, with common terms being five to ten years. Unlike annuities that provide payments for the annuitant’s entire life, this type of annuity concludes payments once the specified term ends. This distinguishes it from traditional lifetime annuities, which offer income for the remainder of an individual’s life. Fixed term annuities also differ from variable annuities, where payouts fluctuate based on investment performance, as payments are guaranteed and do not change.

With a fixed term annuity, the interest rate applied to the funds is guaranteed, providing certainty about the growth of the principal during any accumulation phase. The contract terms dictate the income amount the annuitant will receive, which depends on factors like the initial investment, the chosen term length, and the insurer’s prevailing annuity rates. This financial instrument is considered by those who desire a guaranteed income but prefer not to commit their entire savings for their full lifetime, allowing for future financial planning adjustments.

Operational Mechanics and Key Features

Purchasing a fixed term annuity involves providing funds to an insurance company, either as a single lump-sum payment or through a series of contributions. The funds accrue interest at a guaranteed rate during an accumulation phase until income payments begin. The exact income payments are calculated based on the total amount invested, the length of the chosen term, and the annuitant’s age. Insurers distribute these fixed payments according to the contract’s terms, often on a monthly, quarterly, or annual basis.

The process of converting the annuity investment into a series of periodic income payments is known as annuitization. Once annuitization begins, the terms governing the amount, frequency, and duration of payments are fixed and difficult to change. For deferred annuities, an annuitization date is specified in the contract, after which periodic payments commence. The insurer calculates the payout amounts by considering the accumulated value, current annuitization rates, and the chosen payout option.

When the fixed term concludes, payments from the annuity stop. Many fixed term annuity contracts include a “maturity sum” or “guaranteed maturity value” that is paid out at the end of the term. This sum represents the original investment plus any remaining growth, minus the income payments already received. Annuitants can then use this lump sum as they wish, potentially to purchase another annuity, invest in a different product, or take it as cash.

Fixed term annuities include provisions for death benefits, clarifying what happens if the annuitant passes away before the term ends. A named beneficiary receives the remaining value of the contract or a continuation of payments. The specific payout method, whether a lump sum or continued periodic payments, depends on the contract’s terms and the beneficiary’s choice. Naming a beneficiary ensures the funds bypass probate, facilitating a smoother transfer of assets.

Regarding taxation, annuities offer tax-deferred growth, meaning earnings are not taxed until withdrawn or received as payments. When payments begin, the portion representing investment earnings is taxed as ordinary income. If the annuity was funded with pre-tax dollars, such as from a qualified retirement plan, the entire amount of each payment is taxable. However, if funded with after-tax dollars (non-qualified annuity), only the earnings portion of the payments is subject to taxation, while the return of original principal is tax-free. Additionally, withdrawals or payments received before age 59½ may incur a 10% IRS tax penalty on the taxable portion, in addition to ordinary income tax, unless an exception applies.

Annuities may also involve surrender charges, which are fees assessed if funds are withdrawn prematurely or if the contract is canceled before a specified period, ranging from six to ten years. These charges are designed to discourage short-term use and help the insurer recover administrative costs and commissions. The surrender charge decreases over the surrender period, for example, starting at 7% or 8% in the first year and declining annually until it reaches zero. Many contracts allow for penalty-free withdrawals of a small percentage, up to 10% of the account value, each year without incurring a surrender charge.