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Here's how a fixed annuity works.

A fixed annuity is the most straightforward of annuities. It pays an initial interest rate that is often boosted. Then, according to the contract’s terms, the rate re-sets. So though the rate changes, each rate is fixed for a stated period of time. In this way, a fixed annuity is like a certificate of deposit (CD). At the end of the guarantee period or period you committed to keeping your money in the annuity, you have several options. One is  renewing your contract. Another is annuitizing, which is to receive payments. The insurance company partly bases your payments on how much money is in your account. This is why you want a higher interest rate during the accumulation phase – so your  payments during the annuitization phase will be larger. Learning the ins and outs of fixed annuities can help you decide if they belong in your financial plan.

A Fixed Annuity Defined

First, an annuity is a contract between you and an insurance company. It’s often part of retirement planning, though traditionally, it’s what people bought with their nest eggs when they retired. Now with the passage of the SECURE Act, more savers will have access to annuity products through their 401(k) plans.

Next, there are deferred annuities and immediate annuities. When you are far from retirement, you’re probably buying the former. When you’re retired and want to receive cash payments right away, you’re buying the latter.

Finally, there are different ways annuities grow. As explained above, fixed annuities earn interest at set rates. It does this tax-deferred, which is why there are IRS penalties if you withdraw your money before age 59.5. On the other hand, a variable annuity grows depending on the stock market. So a fixed annuity has less risk.

The annuitization phase begins when the accumulation phase ends and you start receiving payments. The size of the payments depends on the size of your account, age, gender in some states and terms of the contract (for example, if you chose life or life with certain period).

How Does a Fixed Annuity Work?

After you choose an insurance company’s annuity product, you need to pick the length of your guarantee period. This can be one year or anywhere up to 10 years. Typically, the insurance company gives you an initial interest rate, which may last for a year or possibly for the length of your guarantee period. Or it will give you an initial rate for the first year and a guaranteed minimum rate for the duration of your guarantee period. If it’s the latter case, a new rate will set every year.

Often, the guaranteed minimum rate will be higher if you lock in for a longer guarantee period. This is very much like a CD, except, and this is a big except, there are major penalties if you withdraw money before the guarantee period has ended. With a CD, you typically forfeit 90 days of interest for an early withdrawal. With an annuity, you can pay as much as 9% in what the industry calls “surrender charges,” plus 10% IRS early withdrawal fees.

At the end of the guarantee period, you have a number of options. You can renew the contract, transfer your balance to another annuity product or roll over your money to a different kind of retirement account. Or you can annuitize, turning your balance into a stream of income, typically for life.

The rate of return associated with a fixed annuity is what primarily sets it apart from a variable annuity.

Fixed vs. Variable Annuities

Here's how a fixed annuity works.

As its name suggests, a variable annuity delivers a return that changes from year to year (if not quarter to quarter). Instead of a fixed rate of interest, your money grows depending on the investment products you chose, which is to say, depending on the market.

In other words, variable annuities don’t offer a guaranteed return. But in return for the higher risk, you may earn a higher return.

Fixed Annuities: The Pros

There are some features of fixed annuities that make them an attractive choice for retirement planning. Fixed annuities are:

  • Predictable, in terms of the return you can earn on your money.
  • Simple to purchase and relatively easy to understand.
  • Low risk, which may appeal to you if you’re looking for a more conservative investment.
  • Tax-advantaged, in that your money grows tax-deferred the same as it would in a 401(k) or traditional IRA. (Thanks to the SECURE Act, you may soon be able to buy an annuity through your 401(k).)

Compared to a variable annuity, fixed annuities are far less complicated. There are no complex formulas to determine how much your money will grow. There’s also no array of investment options you have to choose from. Additionally, you don’t have to allocate some money this way and other money that way. Your money simply grows at a fixed interest rate that changes periodically.

Fixed Annuities: The Cons

Like any other retirement planning tool, fixed annuities have potential downsides. Here are some reasons you may want to carefully consider a fixed annuity:

  • A variable or indexed annuity, which attempts to match the performance of a particular stock market index, could deliver better returns.
  • Since growth is fixed, there’s no inflationary hedge built-in.
  • In addition to a 10% early withdrawal penalty, you may also pay expensive surrender charges if you need to pull money out of a fixed annuity early.

Certainly, taxes are another consideration. Payments from a fixed annuity are taxed as ordinary income. That could mean a bigger tax bite if you’re in a higher bracket. If you were to keep that money in a taxable account, earnings would be subject to a lower capital gains tax rate.

The Bottom Line

Here's how a fixed annuity works.

Fixed annuities make the most sense for people who are about to retire and are worried that the markets will be volatile when they need to start withdrawing from invested retirement accounts. By rolling over some of their retirement savings into a fixed annuity, they are taking that money out of the markets but still earning a better interest rate than most bank savings rates. Fixed annuities probably make the least sense for people who are decades away from retirement. After all, they have time for their stock investments to recover from any losses.

Retirement Planning Tips

  • Not sure which annuity is right for you? A financial advisor can help. Use SmartAsset’s free tool to find one who matches your needs. It takes just five minutes to get up to three recommendations.
  • Carefully read the annuity contract before signing it. You want to make sure you fully understand what you’re buying, including any fees. Also, take time to run the numbers through an investment calculator to gauge the rate of return and growth you’re likely to see.

Photo credit: ©iStock.com/gazanfer, ©iStock.com/PeopleImages, ©iStock.com/Sezeryadigar

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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