• Allison Hess, CONTRIBUTOR
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March 22, 2018 views: 30,239

A fixed annuity is a simple, secure way to ensure consistent income during your retirement. These annuities guarantee the same payout each month, regardless of the market or your former salary. This creates a level of certainty and security for retirees who are more risk-averse.

What is a fixed annuity?

A fixed annuity is a contract with an insurance company. You trade a lump sum of money in exchange for continuous monthly payouts from the insurer. These annuity distributions or payouts offer guaranteed income to the annuitant over the course of life or a set time period (usually 10-12 years).

You can pay for a fixed annuity in a lump sum or a series of contributions. Once you pay for the total cost of the annuity (accumulation phase), you don’t have to add any more to the account.

The amount that you contribute to your annuity is called a principal. This is usually taxed as income before you put it into the annuity account.  

Fixed annuities guarantee the payout. This means you receive the exact same payouts each month regardless of the market or inflation. This creates portfolio security to ensure you would still have income if the market crashes.

Fixed annuities are most often compared to certificates of deposit (CDs). However, a deferred fixed annuity can often earn a higher interest rate than a bank CD. Also unlike CDs, which are taxed annually with a 1099, fixed annuities defer taxes until payout, so they can grow at a greater rate until annuitization. Most fixed annuities also have a longer term length than typical certificates of deposit.

What are the two types of fixed annuities?

There are two types of fixed annuities: deferred and immediate. A deferred fixed annuity accumulates interest over time before withdrawal begins, while an immediate fixed annuity provides fixed payouts right after the annuity is purchased without gaining interest.

Deferred fixed annuity

A deferred fixed annuity (DIA) accumulates interest over time before the point of annuitization. Annuitization is the point at which you begin receiving payout distributions. This guaranteed interest helps increase the amount of your future monthly payouts.

The interest earned on a DIA is tax-deferred, so you don’t pay income tax until you start taking withdrawals. This helps build your annuity at a greater rate based on a larger amount of cash in the annuity.

When you take a withdrawal, the interest is usually withdrawn first. You then begin to withdraw the principal after the interest is taken out. However, the exclusion ratio will determine how much of the distribution is considered interest versus principal.

Most deferred fixed annuities will allow you to access up to 10% of the contract value each year without paying a surrender charge, which we’ll discuss further below.

Because you don’t start receiving payouts right away, deferred annuities include a guaranteed income rider. This states the specific amount of income you’ll receive when you start taking your annuity payments. This helps secure your future income rate no matter the market.

Who is it for? A deferred fixed annuity is best for someone who is 10-12 years out from retirement. This starts building your retirement fund by gaining interest, but it guarantees a fixed income no matter what the market looks like. Even if the stock market crashes right before you retire, you are entitled to the agreed annuity payout amount.

Learn more about deferred annuity types here.

Immediate fixed annuity

An immediate fixed annuity (also called a single premium immediate annuity or SPIA) begins payouts instantly after purchasing. You exchange a lump sum of money for a guaranteed monthly payout that starts right away. Payouts remain consistent for the length of your annuity time period.

Who is it for? An immediate fixed annuity is best for those who are retired or retiring soon. It’s also a good option if you’re single or recently widowed. It will guarantee income to cover expenses starting instantly. Immediate fixed annuities are one of the safest types of retirement investments for those who are retired or retiring in the near future.

How can I be paid by a fixed annuity?

With a fixed annuity, you’ll work with your insurer to determine the amount you’ll be paid monthly as well as the length of time you’ll receive payments. You can receive a lump sum withdrawal, periodic withdrawals, or a combination of the two. Most fixed annuities are either 10-year limit or over the course of your life.

Types of payouts include –

Straight life: Set dollar amount for the rest of your life. Payments stop at death, even if the total payout is less than original investment value.

    • Joint life: You and a co-beneficiary, like a spouse, receive a set dollar amount for the rest of both of your lives. It’s typically more expensive with lower monthly payouts, but it covers both individuals for life.
    • Life with period certain: This pays a set dollar amount over a set period of time, like 10 or 20 years. These payouts will continue to a beneficiary even after death.  
    • Joint life with period certain: This is the same as the “life with period certain” but it will pay for two co-beneficiaries for a set time period.
    • Systematic withdrawal: You’ll receive a set dollar amount or percentage of contract paid out annually.
  • Lump sum: This liquidates your annuity and gives you a single payment. You might choose this to have access to more cash or to roll the funds into another annuity contract. There is usually a fee for taking a lump sum from an annuity.

Keep in mind that fixed annuity payouts remain consistent—no matter how well or poorly the market does. You will still receive the same payouts, even if there’s significant inflation. You might want to consider purchasing an annuity with a rider that addresses inflation.

How are fixed annuities taxed?

Your contribution to a fixed annuity is tax-deferred. This means that you don’t have to pay taxes on the annuity while it’s gaining interest in the accumulation phase. This allows you to grow your annuity and income before taxes eat at the sum in your account.

You start paying taxes when you begin receiving annuity payouts. The IRS will tax your payments in the same way it would any other type of income—with the typical rate of income tax.

Note that the IRS will tax at a higher rate if you take money out of your annuity before age 59 and a half.

Only interest payouts are taxed. You receive your principal back tax-free.

But how much of each monthly payout is considered interest and how much is considered part of your principle? This balance, aka the amount taxed, is based on the exclusion ratio formula.

For example, you invest $200,000 in a fixed contract. The amount you invest (or use to purchase the annuity) is your principal. Over time, this account doubles to $400,000. You’re receiving payouts of $700 monthly. The exclusion ratio for this would mandate that 50% of the payout is taxed as “interest income” and the other 50% is the principal. This means that you would be taxed on $350 of the $700.

What if I withdraw funds early?

If you withdraw funds from your annuity before age 59 and a half, you’ll face a 10% early withdrawal penalty from the IRS.

You may also face surrender charges from the insurance company. These fees are typically between 7-20%, and they gradually decrease over time. Most will decrease by 1 or 2 percentage points annually.

For example, you have a 10-year fixed annuity contract. The insurer charges a 10% penalty for funds you take out in the first year of purchasing the contract. Then, you’re charged 9% for anything withdrawn the second year, 8% the third year, and so on. The fee will decrease by 1% each year until the surrender expires completely. In this case, the surrender fee will disintegrate in 10 years.

Some deferred fixed annuities will allow you to withdraw up to 10% of the contract yearly without a penalty. This provides you with some liquidity, so you have access to the money if need be.  

What are the advantages of fixed annuities?

Fixed annuities offer guaranteed rates of interest. You don’t have to worry about the status of the stock market. You’ll be protected even if the economy crashes.

This ensures a steady, predictable income for life.

The annuity collects interest tax-deferred until you withdraw. This allows you to grow your investment at a faster rate.

Fixed annuities also offer low investment minimums, around $1,000 to $10,000. This means you can purchase an annuity along with other forms of retirement savings and life insurance.  

You can’t lose your principal (the initial investment) unless the insurance company fails.

What are the disadvantages of fixed annuities?

There is some spending power risk associated with fixed annuities. Most fixed annuities don’t adjust to the cost of living, so you might want to consider purchasing an annuity with inflation protection (though these are more expensive).

You don’t receive any of your principal once it’s given to the insurance company. The annuitant could die a few months after purchasing the annuity, and the insurer does not have to return their money to the family or estate. This creates survivorship risk that could impact the beneficiaries’ future income. You can purchase a supplemental death benefit rider to mitigate this risk.  

Fixed annuities also have fees, including surrender charges, annual fees, commission to agent, and income rider.

The FDIC, SIPC, or other federal agencies do not guarantee private annuities. This means that you could lose your annuity value if your insurance company goes under. However, there are ways to protect against this risk:

    • Make sure your company is in good financial standing. Check S&P and A.M. Best to see your insurance company’s credibility.
    • Check to see if your state has a guaranty association. This requires insurance companies to carry a cash reserve that’s equivalent to the total value of outstanding fixed annuity contracts. This ensures you could be paid back your principal if they fail
  • If your company goes under, reinsurance companies might step in to cover losses.

Note that some fixed annuity contracts will have a “teaser rate.” This is a higher rate for the first year of the contract’s term, but then it decreases in the following years. Other contracts may start with a lower rate and rise each year until maturity.

Conclusion

Fixed annuities are a popular option because they offer a set payout for a specific term limit. It’s a convenient, safe, and predictable way to ensure a steady retirement income.

If you’re interested in a safe method of retirement income, contact a Sunpath agent to start discussing your fixed annuity options.

We look forward to hearing from you today!

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