What Is a Fixed Annuity?

A fixed annuity is a type of insurance contract that promises to pay the buyer a guaranteed interest rate on their contributions to the account. A variable annuity pays interest that fluctuates based on the performance of an investment portfolio chosen by the account's owner.

Fixed annuities are most often used to create a reliable stream of income after retirement.

Key Takeaways

• Fixed annuities are insurance contracts that pay a guaranteed rate of interest based on the amount of the account owner's deposit.
• Variable annuities pay a rate that varies according to the performance of investments chosen by the account owner.
• The earnings in a fixed annuity are tax-deferred until the owner begins receiving income from the annuity.
• Annuities aren't for everyone, as they come with relatively high fees.

How a Fixed Annuity Works

Investors can buy a fixed annuity with either a lump sum of money or a series of payments over time. The insurance company, in turn, guarantees that the account will earn a certain rate of interest during the period known as the accumulation phase.

When the annuity owner, or annuitant, elects to begin receiving regular income from the annuity, the insurance company calculates the payments based on the amount of money in the account, the owner's age, how long the payments are to continue, and other factors.

This begins the payout phase. The payout phase may continue for a specified number of years or for the rest of the owner's lifetime, depending on the annuitant's decision. The annuitant may also arrange for death benefits to be paid to a surviving spouse.

During the accumulation phase, the account grows tax-deferred. Then, the account holder annuitizes the contract.

The distributions paid to the annuitant are taxable based on an exclusion ratio that identifies the taxable amount of the payments. This is the amount that is attributed to investment earnings rather than the post-tax payments into the account. The premiums paid also are excluded from the taxable total.

5 Benefits to Fixed Annuities

1. Predictable Income

The rates on fixed annuities are derived from the yield that the life insurance company generates from its investment portfolio, which is invested primarily in high-quality corporate and government bonds. The insurance company is then responsible for paying whatever rate it has promised in the annuity contract.

This contrasts with variable annuities, which place the investment risk on the annuity owner.

2. Guaranteed Minimum Rates

Once the initial guarantee period in the contract expires, the insurer can adjust the rate based on a stated formula or on the yield it is earning on its investment portfolio. As a measure of protection against declining interest rates, fixed annuity contracts typically include a minimum rate guarantee.

3. Tax-Deferred Growth

Because a fixed annuity is a tax-qualified vehicle, its earnings grow and compound tax-deferred. Annuity owners are taxed only when they take money from the account, either through occasional withdrawals or as regular income.

This tax deferral can make a significant difference in how the account grows over time, particularly for people in higher tax brackets. The same is true of qualified retirement accounts, such as traditional Individual Retirement Accounts (IRAs) and 401(k) plans, which also grow tax-deferred.

4. Guaranteed Income Payments

The annuity will generate a guaranteed income payout for a specified period or for the life of the annuitant. Depending on the contract, the payouts may continue for beneficiaries after the annuitant has died, such as a surviving spouse or dependents.

5. Relative Safety of Principal

The life insurance company is responsible for the security of the money invested in the annuity and for fulfilling any promises made in the contract.

Unlike most bank accounts, annuities are not federally insured. For that reason, buyers should only consider doing business with life insurance companies that earn high grades for financial strength from the major independent rating agencies.