In simple terms, an annuity is a long-term insurance contract between you and a life insurance company. In exchange for a payment or a series of payments, the insurance company guarantees a stream of income, either immediately or at some point in the future.
A fixed annuity is a type of annuity that earns money at a fixed rate of interest. It is a predictable, conservative instrument for retirement planning and saving.
Types of Fixed Annuities
Fixed annuities fall into one of two categories: single-premium or flexible-premium. Single-premium annuities are funded with one lump sum payment and cannot be further contributed to. Flexible-premium annuities give you the option to make additional premium payments if you want.
Fixed annuities can further be classified as either immediate or deferred. Immediate annuities begin paying income immediately. A fixed rate of interest is factored into these payments. Deferred fixed annuities earn interest for a period of years or even decades. These annuities have a stated maturity date. Income payments begin on that date or shortly thereafter.
Overview of a Fixed Annuity
Deferred annuities are the most popular type of fixed annuities, so let’s look at how they work.
The insurance company sets the annuity’s interest rate in advance. Once the contract is issued, the annuity begins earning daily interest. Annuities are tax-deferred, meaning taxes are not due on gains until they are withdrawn. This allows earnings to compound faster than they otherwise would.
Most fixed annuities have a surrender charge, which is a fee that the insurance company collects if money beyond a specified “free amount” is withdrawn from the annuity within the first few years of the contract. The free amount that can be withdrawn is commonly 10% of the annuity’s value per year.
Once the annuity reaches maturity, the contract becomes “annuitized”, meaning the annuity’s value is converted into a stream of income payments. You get to decide how to structure the income. It is common to structure payments for a certain number of years, or even for an entire life.
You can also take the annuity’s value as a lump sum if an income stream is not needed or wanted.
Planning for Retirement with your Fixed Annuity
A fixed annuity’s unique ability to create income guaranteed for life makes it a compelling tool for retirement planning. The predictable earnings potential of a fixed annuity makes it very attractive to conservative investors.
When planning for retirement with a fixed annuity, it is important to consider the tax implications. In a similar fashion as a 401(k) or IRA, withdrawals from an annuity prior to age 59½ are subject to a 10% tax penalty in addition to income tax.
Withdrawals after 59½ are taxable as income – but only the gains in the annuity are taxed. Income payments from “annuitized” contracts have what is known as an exclusion ratio. This represents the portion of the payment that is a return of principal and will be excluded from taxable income because it has already been taxed.
If you die before your annuity matures, the contract value will be paid to the beneficiary you named. If you die during the annuity’s payout phase, the income payments may stop or continue to your beneficiaries, depending on how you structured your payout.