Fixed Annuity

There are three types of annuities: fixed, variable and indexed. Both immediate and deferred annuities can be either fixed or variable, which changes the risk profile of the investment.

Annuities can be classified as either immediate or deferred. With an immediate annuity, an owner makes a single payment to purchase the annuity and typically starts receiving income payments within one year of purchase. With a deferred annuity, an owner makes a single payment or flexible payments over time that allow the accumulation of money for future income. The money paid is allowed to grow tax-deferred before income payments start. This time period during which the money is allowed to grow is called the accumulation phase. For both types of annuities, the period when income payments begin is called the payout phase.

How a Fixed Annuity Works

Fixed annuities guarantee that money will earn at least a minimum interest rate during the accumulation phase. Fixed annuities may earn interest at a rate higher than the minimum but only the minimum rate is guaranteed. The interest rate on a fixed annuity can change over time.

With a deferred fixed annuity, the insurance company agrees to pay no less than a specified rate of interest during the time that the account is growing. With an immediate fixed annuity, or when an owner annuitizes a deferred annuity, the owner receives a predetermined fixed amount of money, usually on a monthly basis, similar to a pension.

An annuity may provide periodic payments for a specific amount of time. The income may be for the rest of the owner's life, the life of a spouse or partner, or some other set period of time. If the owner of an annuity dies before payments start, the person named as beneficiary receives at least the current value of the annuity, perhaps more.

The predictability of a fixed annuity makes it a popular option for investors who want a dependable rate of return and the option to begin a guaranteed income stream to supplement their other investment and retirement income. Fixed annuity payouts are not affected by fluctuations in the market, so they can provide peace of mind for investors who want to ensure that they will have a predetermined amount of money to carry them through retirement and cover identified future expenses.

The Insurer's Guarantee and Its Limits

An insurance company's obligations under an annuity contract are subject to its financial strength and claims-paying ability. If the insurance company has financial difficulties, it may not be able to pay the annuity owner.

There may be state guarantees in the event of an insurance company's failure, but annuities are not guaranteed by the Federal Deposit Insurance Corporation, the Securities Investor Protection Corporation or any other federal agency. With all annuities, an investor should remember that the annuity is only guaranteed as long as the insurance company issuing it remains in business, so the investor will want to be sure of being comfortable with the issuer, not just the product itself. Companies such as Standard and Poor's provide ratings of insurance companies.

How a Fixed Annuity Compares With Other Annuities

In the Investor.gov comparison of annuity types, a fixed annuity is described with the following features. Its common features are tax deferral, guaranteed income, a death benefit and a long term investment. Its growth potential is guaranteed growth at a fixed rate of interest. Its potential for loss is generally none, other than a surrender charge for withdrawals or surrenders taken during the surrender charge period. Its ongoing fees are reflected in the interest rate. Its relative risk is that it is the least risky annuity type and has the lowest potential return. Its typical investor has a long-term time horizon, a very low to low risk tolerance, is looking to protect assets, and seeks a guaranteed, set return.

Unlike a fixed annuity, variable annuities do not provide any guarantee of earning a return on the investment. Indexed annuities expose an investor to more risk, but more potential return, than a fixed annuity, and less risk, and less potential return, than a variable annuity. With the addition of benefits, added as riders to the contract, certain variable annuities can be more expensive than fixed annuities.

An investor considering an exchange of a fixed annuity for a variable annuity should be aware that, unlike a fixed annuity, a variable annuity lacks certain guarantees and can be affected by fluctuations in the market.

Payments in a fixed annuity typically do not have cost-of-living adjustments to keep pace with inflation, so the purchasing power of the money received in the payments may decline over time. Because the interest rate of a fixed annuity may change after an initial fixed period, the returns may end up paying less over time.

Regulation of Fixed Annuities

While all annuities are regulated by state insurance commissioners, variable annuities and registered index-linked annuities are securities and therefore are also regulated by the SEC and FINRA. In the Investor.gov comparison of annuity types, the entry for a fixed annuity under the heading Regulator reads: An insurance product. Regulated by state insurance regulator. Of the four main types of deferred annuities shown in that comparison, registered index-linked annuities and variable annuities are securities that must register with the SEC.

Section 3(a)(8) of the Securities Act of 1933 provides that, except as hereinafter expressly provided, the provisions of the subchapter shall not apply to any of the listed classes of securities, and one of those classes is any insurance or endowment policy or annuity contract or optional annuity contract, issued by a corporation subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any State or Territory of the United States or the District of Columbia.

Rule 151(a) provides that any annuity contract or optional annuity contract, called a contract in the rule, shall be deemed to be within the provisions of section 3(a)(8) of the Securities Act of 1933, provided that three conditions are met. Under paragraph (a)(1), the annuity or optional annuity contract is issued by a corporation, called the insurer, subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any State or Territory of the United States or the District of Columbia. Under paragraph (a)(2), the insurer assumes the investment risk under the contract as prescribed in paragraph (b). Under paragraph (a)(3), the contract is not marketed primarily as an investment.

Rule 151(b) provides that the insurer shall be deemed to assume the investment risk under the contract if three requirements are met. Under paragraph (b)(1), the value of the contract does not vary according to the investment experience of a separate account. Under paragraph (b)(2), the insurer for the life of the contract guarantees the principal amount of purchase payments and interest credited thereto, less any deduction, without regard to its timing, for sales, administrative or other expenses or charges, and credits a specified rate of interest to net purchase payments and interest credited thereto. Under paragraph (b)(3), the insurer guarantees that the rate of any interest to be credited in excess of that described in paragraph (b)(2)(ii) will not be modified more frequently than once per year.

Rule 151(c) provides that the term specified rate of interest means a rate of interest under the contract that is at least equal to the minimum rate required to be credited by the relevant nonforfeiture law in the jurisdiction in which the contract is issued. If that jurisdiction does not have any applicable nonforfeiture law at the time the contract is issued, or if the minimum rate applicable to an existing contract is no longer mandated in that jurisdiction, the specified rate under the contract must at least be equal to the minimum rate then required for individual annuity contracts by the NAIC Standard Nonforfeiture Law, the abbreviation NAIC standing for the National Association of Insurance Commissioners.

Surrender Charges

If an annuity owner takes a withdrawal of some or all of the contract value within a certain number of years of purchasing or contributing money to the annuity, the amount withdrawn may be subject to a surrender charge. Surrender charges will reduce the value of, and the return on, the investment. Many annuities charge a fee if money is taken out of the annuity within a certain number of years of purchasing or contributing money to the annuity. Generally, these fees decrease over time.

Many annuities have set holding periods and surrender charges for those who want to withdraw their cash early. The surrender charge, sometimes referred to as a contingent deferred sales charge, is the penalty fee owed by a contract owner who sells or withdraws money from the annuity during the surrender period. The surrender period is a set period of time after the purchase of an annuity during which the owner cannot surrender the annuity without penalty. The surrender period will be detailed in the annuity contract.

Many deferred annuities let an owner withdraw money during the accumulation phase. If an owner takes all of the money out at once, this is often called a surrender and terminates the annuity. When exchanging an annuity, the owner may be subject to a surrender charge when exiting the old annuity. Upon exchange, the owner may also be subject to a new surrender charge period associated with the new annuity.

Tax Treatment of Annuities

Annuities provide tax-deferred growth until the owner begins receiving income payments. An owner pays no taxes on any interest or investment gains in the annuity until the owner withdraws the money, receives income payments, or a death benefit is paid. Withdrawing money from an annuity may be a taxable event. Money invested in annuities grows on a tax-deferred basis. Investments in nonqualified annuities are made with after-tax dollars, meaning the contributions to an annuity cannot be deducted from taxable income. When money is taken out of an annuity, gains are taxed at ordinary income rates.

If an owner withdraws money from an annuity before age 59 ½, the owner may have to pay a 10 percent tax penalty to the Internal Revenue Service on top of any taxes owed on the withdrawal. If an owner is investing in an annuity through a tax-deferred retirement plan, the owner does not get any additional tax deferral, and the annuity will be taxed like any other investment in the plan. If certain tax rules are followed, an exchange of one annuity for another may not trigger a taxable event. The federal tax rules that apply to annuities can be complicated, tax laws and tax rates also change over time, and there may be state tax implications.

Section 72(a)(1) of the Internal Revenue Code provides that, except as otherwise provided in the chapter, gross income includes any amount received as an annuity, whether for a period certain or during one or more lives, under an annuity, endowment, or life insurance contract.

Section 72(b)(1) provides that gross income does not include that part of any amount received as an annuity under an annuity, endowment, or life insurance contract which bears the same ratio to such amount as the investment in the contract, as of the annuity starting date, bears to the expected return under the contract, as of such date. Section 72(b)(2) provides that the portion of any amount received as an annuity which is excluded from gross income under paragraph (1) shall not exceed the unrecovered investment in the contract immediately before the receipt of such amount.

Section 72(c)(1) provides that, for purposes of subsection (b), the investment in the contract as of the annuity starting date is the aggregate amount of premiums or other consideration paid for the contract, minus the aggregate amount received under the contract before such date, to the extent that such amount was excludable from gross income under the subtitle or prior income tax laws. Section 72(c)(4) provides that, for purposes of the section, the annuity starting date in the case of any contract is the first day of the first period for which an amount is received as an annuity under the contract.

Section 72(e), titled Amounts not received as annuities, applies to any amount which is received under an annuity, endowment, or life insurance contract and is not received as an annuity, if no provision of the subtitle other than the subsection applies with respect to such amount. Section 72(e)(2) provides that any amount to which the subsection applies, if received on or after the annuity starting date, shall be included in gross income, or, if received before the annuity starting date, shall be included in gross income to the extent allocable to income on the contract, and shall not be included in gross income to the extent allocable to the investment in the contract. Section 72(e)(3)(A) provides that any amount to which the subsection applies shall be treated as allocable to income on the contract to the extent that such amount does not exceed the excess, if any, of the cash value of the contract, determined without regard to any surrender charge, immediately before the amount is received, over the investment in the contract at such time. Section 72(e)(3)(B) provides that any amount to which the subsection applies shall be treated as allocable to investment in the contract to the extent that such amount is not allocated to income under subparagraph (A).

Section 72(q)(1), titled Imposition of penalty, provides that if any taxpayer receives any amount under an annuity contract, the taxpayer's tax under the chapter for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income. Section 72(q)(2) provides that paragraph (1) shall not apply to any distribution in ten listed cases. Those cases are a distribution made on or after the date on which the taxpayer attains age 59½, a distribution made on or after the death of the holder or, where the holder is not an individual, the death of the primary annuitant, a distribution attributable to the taxpayer's becoming disabled within the meaning of subsection (m)(7), a distribution which is a part of a series of substantially equal periodic payments, not less frequently than annually, made for the life or life expectancy of the taxpayer or the joint lives or joint life expectancies of such taxpayer and his designated beneficiary, a distribution from a plan, contract, account, trust, or annuity described in subsection (e)(5)(D), a distribution allocable to investment in the contract before August 14, 1982, a distribution under a qualified funding asset, a distribution to which subsection (t) applies, a distribution under an immediate annuity contract, and a distribution which is purchased by an employer upon the termination of a plan described in section 401(a) or 403(a) and which is held by the employer until such time as the employee separates from service.

Common Misunderstandings

The corrections below come from the Investor.gov pages on annuities, the FINRA annuities page, Section 3(a)(8) of the Securities Act of 1933, Rule 151 and Section 72 of the Internal Revenue Code.

The rate on a fixed annuity never changes. The interest rate on a fixed annuity can change over time, and because the interest rate of a fixed annuity may change after an initial fixed period, the returns may end up paying less over time.

The insurance company guarantees any return above the minimum. Fixed annuities may earn interest at a rate higher than the minimum but only the minimum rate is guaranteed.

A fixed annuity is guaranteed by the government. Annuities are not guaranteed by the Federal Deposit Insurance Corporation, the Securities Investor Protection Corporation or any other federal agency, and an annuity is only guaranteed as long as the insurance company issuing it remains in business.

Fixed annuity payments keep up with inflation. Payments in a fixed annuity typically do not have cost-of-living adjustments to keep pace with inflation, so the purchasing power of the money received in the payments may decline over time.

A fixed annuity is a risk-free investment. In the Investor.gov comparison, the potential for loss in a fixed annuity is generally none, other than a surrender charge for withdrawals or surrenders taken during the surrender charge period, and an insurance company's obligations under an annuity contract are subject to its financial strength and claims-paying ability.

Contributions to a nonqualified annuity are deductible. Investments in nonqualified annuities are made with after-tax dollars, meaning the contributions to an annuity cannot be deducted from taxable income.

Annuity gains are taxed at capital gains rates. When money is taken out of an annuity, gains are taxed at ordinary income rates.

Withdrawals can be made at any time without cost. If an annuity owner takes a withdrawal of some or all of the contract value within a certain number of years of purchasing or contributing money to the annuity, the amount withdrawn may be subject to a surrender charge, and a withdrawal before age 59 ½ may also carry a 10 percent tax penalty.

Every annuity is regulated the same way. While all annuities are regulated by state insurance commissioners, variable annuities and registered index-linked annuities are securities and therefore are also regulated by the SEC and FINRA.

Key Points

A fixed annuity is an insurance product that promises a minimum rate of interest while the account is growing, and the insurance company guarantees both the rate of return and the payout to the investor.

Fixed annuities may earn interest at a rate higher than the minimum but only the minimum rate is guaranteed.

An annuity is only guaranteed as long as the insurance company issuing it remains in business, and annuities are not guaranteed by the Federal Deposit Insurance Corporation, the Securities Investor Protection Corporation or any other federal agency.

Payments in a fixed annuity typically do not have cost-of-living adjustments to keep pace with inflation.

A fixed annuity is an insurance product that is regulated by the state insurance regulator, and Rule 151 sets conditions under which an annuity contract is deemed to be within Section 3(a)(8) of the Securities Act of 1933.

Annuities provide tax-deferred growth until the owner begins receiving income payments, and gains taken out of an annuity are taxed at ordinary income rates.

Section 72(q)(1) increases the tax on the includible portion of an amount received under an annuity contract by an amount equal to 10 percent of that portion, subject to the exceptions in Section 72(q)(2).