What Is a Fixed Annuity?

Fixed annuities are conservative investments.

They are typically used for retirement planning, and they might also be used strictly for their tax benefits. You can use them to accumulate money, or to take income from your assets once you retire. They are very appealing to people who don’t want to lose money in the markets, but their safety comes at a cost: as with most conservative investments, investors need to be willing to accept lower returns that might not keep up with inflation (the trade-off being that they’re not likely to lose money).

What Is a Fixed Annuity?

Before going into the pros and cons of using these investments, it’s probably best to review what fixed annuities are and how they work. A fixed annuity is an insurance contract. As part of that contract, the insurance company agrees to pay you interest (they’ll quote the minimum rate, and they may or may not pay you more than that).

The word “annuity” refers to annual payments. However, using a fixed annuity doesn’t necessarily mean that you will ever sign up for annual payments from the contract – it’s just an option that you can use if you want. But you can also just use an annuity for accumulating assets (and then take your assets elsewhere at some point in the future).

How It Works

When you use a fixed annuity, you put money into an account so that it will grow. Similar to what you’d see in a bank account, interest is paid on top of your initial investment. In fact, a fixed annuity looks and feels very much like a certificate of deposit (CD), so comparing and contrasting the two may help you get a better handle on things. Some similarities include:

  • An interest rate is quoted to you before you invest
  • You have to keep your money invested for a set amount of time (you can pull it out early, but you may have to pay a penalty – but fixed annuities typically charge a much steeper penalty than you’d pay for an early CD withdrawal)
  • They are conservative investments, which don’t go up and down along with the stock markets

That said, fixed annuities are not CDs, and there are some important differences:

  • A fixed annuity is issued by an insurance company – not a bank
  • The money in an annuity is not guaranteed by the federal government
  • Annuities often use “surrender charges” to encourage you to keep your money in the account (if you pull your money out early, you might pay a hefty fee. However, you can typically withdraw up to 10% of your initial investment per year without penalty)
  • Annuities can provide tax deferred growth
  • Your interest rate might change from year to year with a fixed annuity, but most CDs pay the same rate every year

Tax Deferral

Fixed annuities are tax deferred investments. That means that any earnings from your annuity (interest payments you receive) are not taxed until you take them out of the account. This feature can be attractive to high income earners who don’t want additional income creating additional taxes on their returns. However, like other tax deferred investments such as a traditional IRA or your 401(k), that benefit comes at a price: the IRS discourages you from taking that money out at a young age, and may penalize you for taking money out before you turn 59 1/2 years old (there are of course some exceptions that can help you dodge the penalty).

Tax deferral is often used as a selling point for fixed annuities, but keep in mind that you only benefit from it if your money was not already tax deferred. If you’re talking about money in a 401(k) plan or IRA, the tax deferral in an annuity is irrelevant – you can’t benefit from double tax deferral. Again, the tax deferral from fixed annuities is most beneficial to high income earners who have substantial assets in otherwise taxable accounts.

Note that if you do use a fixed annuity for non-tax-deferred money (if the money didn’t come from your 401(k) or IRA, for example), any money you withdraw is treated as last in, first out (LIFO). That means you have to pay taxes on your interest earnings before you can start spending your original principal. However, you might be able to change this and get more favorable tax treatment by taking a lifetime income stream from the insurance company: part of each payment would be taxable, and part of it would be a return of your initial investment.

Finally, be aware that any taxes you pay on annuity earnings are paid at ordinary income rates. Those rates are generally higher than tax rates for long term capital gains and some dividends. If you’re attracted to an annuity for tax deferral, make sure you evaluate whether or not you’ll really come out ahead.

Getting Money Out

How do you get money out of a fixed annuity? Like many other types of accounts, you can just call the insurance company and ask them to send money. Of course, you want to make sure that you are allowed to access the money without paying a surrender charge.

If you want to move your assets from a fixed annuity to another account, you can typically do so as a transfer. For example, if you have IRA money in a fixed annuity, you can transfer that money to a different IRA that is not an annuity contract with an insurance company (it might just be an IRA made up of mutual funds).

You can also turn your fixed annuity into a source of income. Through a process called “annuitization” the insurance company will make payments to you for the rest of your life or for a set number of years (10 or 20, for example). This arrangement might look and feel a lot like a pension plan. Depending on your needs, you can choose how the payments come out and if you want the payments to last for your spouse’s lifetime as well. For more information, read up on lifetime annuities.

Once you annuitize, you can’t go back: there’s no way to take a lump sum of cash out of the contract. It may be possible to sell your future payments for one larger payment today, but it’s difficult and expensive.

Fixed Annuity Tips

If you’re considering using a fixed annuity, familiarize yourself with some of the “gotchas.”

Teaser rates: fixed annuities often use teaser rates. In advertisements and marketing materials, the insurance company may offer to pay an extremely attractive interest rate. If you look closer, you’ll see that you only earn that rate for the first year or so – after that, you earn a lot less. Don’t just look at the glossy materials with smiling faces. Read the fine print so that you know what will happen year-by-year.

Renewals: your fixed annuity will be renewed from time to time, depending on what you sign up for (every five years, for example). When renewal time comes, you have an opportunity to move your money elsewhere without paying surrender charges. You can move it to a different annuity, cash it out, or do whatever you want (remember that you might owe taxes if you pull the money out). Be sure to keep up with when your annuity renews, because contracts will often renew automatically, and you might be locked in for another 5 years or more.

Surrender charges: as has been hinted at, surrender charges can be costly. Insurance companies really want you to stay with them – so much so that they’ll ding you for walking away early. Surrender charges often start around 7% (but they can be higher), meaning you’ll pay 7% of any money you pull out of a fixed annuity early. The surrender charge is calculated after you’ve taken any free money available, and they tend to decrease a little bit each year – but renewals can start everything over.

Pros and Cons of Fixed Annuities

Given what you’ve just read, it’s probably easy to pick out the pros and cons of fixed annuity contracts. Things that make them attractive include:

  • The potential to benefit from tax deferral
  • A decent rate of return for ultra conservative investors
  • The ability to set up a lifetime income stream

Things that make fixed annuities unattractive include:

  • Surrender charges, or the need to keep your money locked up
  • Complicated teaser rates
  • Taxes and (possibly) penalties on non-retirement money
  • Returns might not keep up with inflation

For more information, see Are Annuities a Good Investment?