All about fixed annuities
Fixed annuities are one of the oldest existing savings vehicles, believed to date back to the time of Caesar. They are known to have been used in the United States — before independence — in the 17th century to support church pastors.
They continue to be popular today because of their simplicity and effectiveness in helping people save and generate retirement income.
How fixed annuities work
A fixed annuity is a contract with an insurance company. You make a single purchase payment or a series of payments to the company. The annuity can provide a lifetime stream of income or payments over a contractually defined term. Both the interest rate earned on the annuity and the amount of income payments are fixed, as opposed to variable annuities in which interest earned and income payments will vary based on investment performance.
Fixed annuities are often compared to CDs in that they pay a guaranteed rate of interest. Annuities typically pay a higher rate of interest than CDs.
They appeal mostly to retirees who want the convenience and predictability of a set payout, and who want at least some of their retirement assets shielded from market downturns.
Fixed annuities charge annual fees that may total 2 percent to 3 percent or more of the account value. These include a mortality and risk expense charge, and an administrative fee. There will also be fees for any optional benefits (see below).
Fixed immediate annuity vs fixed deferred annuity
You can purchase a fixed immediate annuity if you need income right away. Or you can buy a fixed deferred annuity to take income after you’ve owned it for several years.
With a fixed immediate annuity, you give an insurance company a one-time premium payment. The company subtracts fees from that premium, then calculates your lifetime income payment based on your age and gender. The older you are when you buy the annuity, the higher your income payments.
A fixed deferred annuity allows you to defer your income stream for several years. During the accumulation phase, the annuity’s account value grows tax-deferred based on the fixed rate of interest set by the insurer.
You will be required to leave most or all of the money in the annuity for at least a set period of time before you can take withdrawals. This will be determined before you purchase the annuity. The length can range from 3 to 15 years. At the end of that period, called a surrender period, you can either begin taking income or you can renew the annuity for another period, though it will likely be at a different interest rate.
When it comes time to take income, you can choose a lump sum of your account value or a stream of periodic payments. With the stream of payments, you can choose how long you want to receive income, be it for a set number of years or for life.
Free withdrawals and surrender charges
If you decide to remove some or all of your money from the annuity before its surrender period, you will likely have to pay a surrender charge. This is typically a percentage of the amount withdrawn. The percentage will decline over time. For example, your annuity may have an 8 percent surrender charge if you withdraw funds in the first year, a 7 percent charge in year 2 and a 6 percent charge in year 3.
Many annuities, however, offer a free withdrawal percentage. This provision allows you to take out a percentage of the annuity’s value without a charge. A typical free withdrawal amount is 10 percent of the account value.
How fixed annuities are taxed
Money deposited in a fixed annuity grows tax-deferred until you take distributions. Because of this, you must wait until age 59 1/2 to withdraw funds from the annuity. Doing so prior to age 59 1/2 will result in a tax penalty.
You will not pay tax on the portion of your payments that is considered a return of your original premium. The taxable portion is what your annuity pays above and beyond what you put into it. For example, if the value of your annuity doubles what you deposited, then half of your income withdrawals will be taxed as regular income. The other half will be considered a return of your principal.
If you transferred money from a 401(k) or IRA, your annuity payments will be taxed as regular income, since you would not have paid taxes on the gains in those investments prior to depositing them in the annuity.
Optional features and benefits
Insurance companies offer some options to these products to make them more flexible, including:
Income rider: This is an optional benefit that can be attached to an annuity for an additional annual fee. It provides a lifetime income stream that you can turn on in the future. It also gives you the flexibility of stopping income and restarting it again. The value of an income rider grows at a contractually guaranteed rate. This value is not available for a lump sum, only as a source of lifetime income payments.
Premium bonus. Some companies offer a bonus at the beginning of the contract, typically1 percent to 5 percent of the amount of premium you pay. So if you put $100,000 into a variable annuity with a 5 percent premium bonus, your contract will begin with a value of $105,000, minus fees and expenses. Keep in mind that fees and expenses may be higher with a premium bonus product than with a regular annuity.
No surrender charges. Some annuities offer contracts with no surrender periods, which means no charges for withdrawing money. However, the fees for these annuities will be higher than for those with surrender periods.
Return of Premium. This type of immediate annuity guarantees you or your beneficiaries will receive an amount equal to your initial premium, regardless of when you pass away.
Increased income for confinement or illness. Another new option some companies offer is an increase in the income payments, up to double, in the event you become terminally ill or confined to a nursing home or other care facility. This feature is often included with an income rider.