How a Fixed Annuity Fits a Retirement Plan
A fixed annuity is a contract with a life insurance company that provides income to those in retirement. The product allows the policyholder to deposit a lump sum which will grow to provide tax-deferred income later. The insurance company guarantees the rate of interest—fixed interest—you will earn on money deposited in the annuity contract. There are two main types of fixed annuities, deferred and immediate.
Basics of a Fixed Annuity
A fixed annuity is most comparable to a certificate of deposit (CD) issued by a bank or other financial institution. Except with a fixed annuity, the interest you earn accrues inside the annuity and is not taxable until you withdraw it from the annuity fund. With a CD the bank sends you a 1099-INT tax form each year which reports the amount of interest you earned. You must report this interest on your tax return even if you let it accrue in the CD.
Like a CD, a fixed annuity pays a guaranteed return. Sometimes the return is front-loaded, so there may be a higher interest rate in year one, and a lower rate in years two through ten. Like a CD, there is a term assigned, such as a five-year fixed annuity. Some fixed annuities have their terms as long as fifteen years. If you surrender the annuity before the term is up you will pay a surrender charge.
Different insurance providers will offer products with different interest structures. Don't get caught up by the high first-year interest rate. You need to calculate the yield the product provides if held for the full term of the contract to accurately compare one offering to another.
If you have a long time-frame and want a no-risk investment, you might pick a fixed annuity over a CD to defer the taxes, and possibly earn a higher interest rate than what the banks are paying. This might be a good choice for funds you inherit or a bonus you receive.
Deferred Fixed Annuities
With a deferred fixed annuity—often called deferred income annuities (DIAs)—you receive a guaranteed amount of interest that accumulates inside of the annuity contract. The interest is tax-deferred, so no income taxes are paid until you take a withdrawal.
You can buy a deferred fixed annuity with IRA money, in which case the tax rules that apply to IRAs will apply to all funds in the annuity. These tax rules include contribution limits, the type of investment held, and the required minimum distributions (RMDs). You can also buy a deferred annuity with non-qualified money (non-IRA funds).
Withdrawals From Deferred Fixed Annuities
Withdrawals taken before age 59 1/2 may be subject to penalty taxes as well as income taxes. Also, when you need to make a withdrawal, interest is withdrawn first before the principal.
Once you have withdrawn all the interest the account has accumulated over the years, then you begin to withdraw the principal. This principle is a return of what you put in—your cost basis. Principal withdrawals are not taxed. Most deferred fixed annuities have a feature that allows you to access up to 10% of the contract value each year without having to pay the surrender charge.
If you are looking for the highest interest rate, you can compare deferred fixed annuity rates to alternatives that may offer more flexibility, such as certificates of deposits, or a ladder of high-grade bonds that allow you to keep your principal with minimal restrictions on accessing your money.
Income Rider Benefits
Many deferred fixed annuities offer additional benefits beyond the guaranteed rate. For example, they may have a guaranteed income rider. This clause—rider—states the specific amount of retirement income that can be paid out to you ten or twelve years in the future.
With this type of product, you are buying it to secure a certain outcome or future income. Now, it is not about getting the highest rate of return, instead, it is about making sure you have a minimum amount of guaranteed income for your retirement years.
Deferred fixed annuities with income riders can be a good fit for someone who is about ten years away from retirement. If the market drops right near your retirement date, it won't matter. This product guarantees the future income it will pay out to you no matter what the market does.
Fixed Immediate Annuities
Immediate annuities are marketed as "income for life" products. They pay a set dollar amount each month for a set period such as 10 or 20 years. You can also buy a life annuity that provides income for your life and joint life options that can include the life of a second individual. Some options allow the return of any unused funds to be given directly to your heirs.
With an immediate fixed annuity, you exchange your lump sum of money for a guaranteed payment of income from the insurance company that starts right away. Perhaps you inherited a large sum or sold a business, you can use these funds to buy the immediate annuity. These products are called single premium immediate annuities (SPIAs). Once the annuity payments begin, they do not change unless you purchase an annuity that adjusts with inflation.
When the annuity income payments start, you no longer have access to the principal. Instead, you have a right to the income the insurance company has promised you. The provider used life expectancy and actuarial tables to determine how much income they could pay based on your lump-sum deposit.
You will choose the term of your payments, such as guaranteed income over ten years, or over your entire lifetime. A fixed immediate annuity can be an appropriate addition to your retirement plan if you are:
- Retired, or retiring soon
- Wanting to make sure more of your expenses are covered by guaranteed income
- Risk-averse and prefer safe investments
- Single or recently became widowed
- Concerned about spending your funds too quickly
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.