Fixed annuities are a contract between you and an insurance company that lets you build up capital in a tax-deferred manner. When the contract begins, you pay a lump sum to the insurance company and they agree, in writing, to pay a fixed rate of interest on the investment. At the same time, the company also guarantees the principal amount in full.
Annuitants, which is what investors are called, can opt to get monthly payouts for life or to take payouts for a fixed term of time, like 20 or 30 years. The contract specifies what happens to any remaining funds should the annuitant die before payouts equal principal.
About Fixed Annuities
Many people planning for retirement or looking to provide a guaranteed stream of income for themselves turn to annuities. But there’s a lot to know about these rather complex insurance products. Before putting retirement money or savings into an annuity, take time to know the key facts about one of the two main types of these structured insurance products: Fixed Annuities.
What is a Fixed Annuity?
In the most basic terms, an annuity is sold by an insurance company and offers a fixed rate of return. The primary advantage and selling point is protection against the risk outliving longer than your money. No one wants to run out of financial resources, especially in old age. People want to have a safe form of retirement income. Contracts like these were created by life insurance companies to guarantee a fixed amount of income to those who own the contracts, who are called “annuitants.”
In much the same way that you insure your home or car, you use an annuity contract to insure your income. In exchange for this guaranteed income, you pay the insurance company a lump sum at the time the contract is signed. The vast majority of people who buy annuity contracts use savings or retirement money to make the initial payment to the insurance company.
A fixed annuity can pay you a fixed sum monthly or yearly, and there are endless ways you can set up the contract so that you can get your principal back if you decide you want out of the annuity contract. See the list of advantages and disadvantages below for the basic pros and cons.
The Advantages
The majority of people who purchase an annuity are looking for a way to defer income tax on retirement savings. Like a certificate of deposit (CD), a fixed annuity lets you delay payment of taxes until you start receiving payouts from the annuity. The principal is guaranteed and the interest earned is not taxed. What are the specific benefits of this type of account?
Returns are guaranteed
Whatever you put into the annuity will grow at a guaranteed, fixed-rate throughout the life of the contract. Compared to CDs, fixed annuities typically carry higher rates of return.
Growth is tax-deferred
The IRS views annuity contracts as a form of retirement savings and treats them almost as if they were standard IRAs. In other words, there are no taxes until you take a distribution. CD owners have to pay taxes every year on earnings. This is not the case for those who have their money in an annuity.
Your principal is fully protected
The fixed type of annuity carries no market risk. That means the principal builds up at a fixed rate and is guaranteed. This is the big selling point for people who wish to fully protect retirement income.
They are liquid
In most cases, these instruments allow the contract owner to withdraw up to 10 percent of the total value of the investment each year with no penalties if he/she is over 59.5 years old.
They’re simple
An annuity is one of the simplest of retirement savings vehicles. If you let your initial investment stay in the annuity until the maturity date, you only have to concern yourself with your rate of return and the amount of time until the full amount is available. Fees and early withdrawal penalties are spelled out in the contract.
Risks
No investment arrangement is perfect. The typical annuity has its downside like everything else out there. Here are some of the most common disadvantages of purchasing one.
There are penalties for early withdrawal
If you withdraw money too early, the IRS will be able to hit you with a 10 percent penalty and charge you for tax on the amount you take out as if it were regular income. Plus, insurance companies often impose their own fees for taking funds out of the account before you reach retirement age.
You are banking on the insurance company’s solidity
Funds are not insured by any national entity or the federal government. In fact, the insurance company itself is the only guarantor on the contract, even though many of the rules are governed by state law. Some, but not all, states have guaranty associations that can insure up to $100,000 of the contract amount in certain cases.
Return of principal can be problematic
Contracts differ, but some do not return the principal to the contract holder upon death. Instead, the insurance company can retain the entire amount that has not been paid out.
Key Things to Remember
The chief advantages of fixed products include:
Deferred Tax Liability
Guaranteed Rates of Return
Competitive interest rates compared to similar bank products
It’s always important to thoroughly research the company issuing the contract and the structure of the contract before committing any amount of funds to an annuity account.