Fixed annuities are low risk investments that guarantee a monetary payout and a set rate of return.
What Is a Fixed Annuity?
A fixed annuity is a financial contract that guarantees a rate of interest on any money deposited into the annuity account. This annuity type accrues interest over time on a tax-deferred basis, and provides a consistent income stream.
Unlike variable annuities that provide inconsistent payout amounts based on a fluctuating financial market, a fixed annuity ensures the amount an annuity owner, or annuitant, receives is consistent. This investment tool is considered low risk because there is a set interest rate unaffected by the performance of outside investments like mutual funds, stocks and bonds.
How Do Fixed Annuities Work?
Fixed annuities guarantee a rate of return for the duration of the contract, and a steady income stream for the remainder of your life or for a set period of time.
After paying for the principal using a lump sum or monthly premium payments, the principal will grow tax-deferred during the accumulation phase of the contract. This amount plus interest will later be disbursed as regular monthly, quarterly or annual payments.
Fixed annuity assets are not taxed until withdrawn from the account. If over the age of 59 ½ years old, annuitants can make withdrawals of up to 10 percent of the annuity account value without penalty. If under the age of 59 ½, early withdrawals will be subject to a 10 percent IRS penalty.
Fixed annuity disbursements can be deferred or immediate. In a fixed deferred annuity, the payout is disbursed later in life and allows for the investment to accrue interest until the distribution phase. A fixed immediate annuity disburses income immediately after purchase for a set period of time.
Annuitants can also choose to elect a death benefit within their fixed annuity contract. In the event the annuitant dies before all assets have been disbursed, all remaining investments can be transferred to a spouse or other beneficiary. The beneficiary will also inherit all taxes owed on the remaining funds.
Fixed Annuity Types: Life vs. Term Certain
There are two main types of fixed annuities: life annuities and term certain annuities. While both options provide a guaranteed payout, they differ in how long the distribution phase lasts.
Term certain annuities disburse a set amount of income through a specified date. However, this annuity option does not account for the annuitant’s current health condition or life expectancy. If the annuitant dies before the end of the set term, all remaining assets are surrendered to the insurance company. If the term ends before the annuitant’s death, all disbursement will end.
Life annuities, on the other hand, provide a set amount of income until the annuity owner dies. If an annuitant dies before receiving the entire value of their annuity investment, they risk losing the remainder of their principal if a beneficiary is not selected. There are two primary life annuity options:
- Single-Life Annuity – This annuity option guarantees a payout until an annuitant’s death. It is only valid for one person, and typically offers a higher payout rate than a joint-life contract.
- Joint-Life Annuity – If annuity owners are looking to secure their financial futures and those of their spouses, they may elect a joint-life annuity. This annuity option ensures that if an annuity owner dies before all assets have been disbursed, the surviving spouse or beneficiary will receive the income until their death.
Fixed Annuity Pros and Cons
As with any financial investment, fixed annuities have their share of benefits and risks. Some of the major advantages from investing in a fixed annuity include:
- Guaranteed Income – Fixed annuities ensure a steady stream of income payments for a designated amount of time. The payout amount will not fluctuate based on the financial market, and remaining assets have the ability to transfer to a surviving beneficiary in the event the annuity owner dies.
- Tax Deferred – Annuity assets from this investment grow tax deferred, meaning any contribution to the annuity account can accrue interest tax free until the distribution phase.
- Death Benefit – In the event an annuity owner dies before the end of the contract term, the annuitant can elect to have a spouse or beneficiary receive the remaining funds. Without a death benefit, funds will be surrendered to the issuing insurance company.
On the other hand, fixed annuities carry a number of drawbacks, including:
- Additional Fees – Like many annuity options, fixed annuities are subject to a number of fees and expenses. Some of the most common include commission fees, mortality and expense fees, and administrative fees.
- Surrender Charge – In addition to commission and management fees, insurance companies and the IRS will charge an early withdrawal fee if an annuitant withdraws more than 10 percent of the annuity value from the account before the disbursement term, or if assets are withdrawn before the annuitant reaches the age of 59 ½.
- Limited Flexibility – Once the contract is set, altering the terms can be difficult, specifically once it reaches the distribution phase. This leaves little-to-no window of flexibility in the event an annuitant needs additional funds for a medical or financial emergency.
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