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How a Fixed Deferred Annuity Works


Annuities are insurance policies that are popularly used by retirees for retirement income. While many investors purchase annuities with a lump sum of money, others contribute to their annuities over a longer period of time. A fixed deferred annuity accepts contributions all at once, or over a preset period of time to build up the account balance as your budget allows. Fixed deferred annuities also have some downsides, along with some very important characteristics you’ll want to understand thoroughly. Consider working with a financial advisor as you evaluate various options for generating retirement income.

What Is a Fixed Deferred Annuity?

A fixed deferred annuity is an insurance contract that allows for periodic or lump-sum contributions. Insurance companies invest annuity contributions in stable-value investments that offer returns comparable to CDs and U.S. Treasuries. Your money grows – albeit modestly – tax deferred each year and your balance increases based on guarantees, investment performance and additional contributions.

“Deferred” refers to the annuity having special tax advantages during its growth stage. Similar to a 401(k) or traditional IRA, the assets in your fixed deferred annuity can earn returns without them getting taxed. However, once you reach retirement age and begin taking withdrawals from your annuity, the IRS will charge you normal income tax rates.

How a Fixed Deferred Annuity Works

With a fixed deferred annuity, you open your account with an initial contribution. The annuity contract generally locks in a guaranteed interest rate for a set period of time. When that guarantee expires, you’ll receive the current interest rates. However, most annuities offer a minimum guaranteed interest rate that your current rate cannot fall below.

Additional contributions can be made on a set schedule or on an ad hoc basis. Each contribution you made serves to increase the potential annuitization income available in retirement. While you make contributions to your annuity, this is known as the accumulation phase.

When you make a withdrawal, a portion of the proceeds is taxable. However, unlike a traditional IRA or 401(k) account, there are no annual required minimum distribution (RMD) amounts when you reach age 72. This means that you can let the balance continue to grow for as long as you wish.

Fixed Deferred Annuity Maturities

Fixed Deferred Annuity

When your fixed deferred annuity matures, you have multiple options for your account balance. You can withdraw your entire balance to use as you wish, providing you with the most flexibility. A lump-sum withdrawal will trigger the largest tax bill since you’ll receive all of your deferred gains at once.

Alternatively, you can keep the balance within the annuity. It will earn market rates and your account will continue to grow tax-deferred. Or you can perform a tax-free rollover to another annuity without paying a penalty or taxes. This is known as a 1035 exchange. Finally, you can opt for annuitization, which creates a stream of income that you cannot outlive. You’ll receive monthly payments for the rest of your life no matter what happens in the stock market. Your monthly payments will be part interest (taxable) and part principal (non-taxable).

Pros and Cons of Fixed Deferred Annuities

There are three main benefits to fixed deferred annuities. These annuities offer a guaranteed interest rate for a certain period of time. Afterward, interest rates may adjust each year or over multiple years, which could end up being a good or bad thing depending on the state of the market. In addition, the earnings from a fixed deferred annuity grow tax-deferred, meaning earnings are not taxable until you withdraw them.

Rounding out this trio of perks is that many fixed deferred annuities allow you to withdraw a portion of your balance without penalty each year. However, during the first few years of owning the annuity, withdrawals may be subject to a surrender charge if you go over the allotted amount.

Several features of fixed deferred annuities can make them unsuitable for some retirees. Firstly, annuities are not FDIC-insured like a CD. Instead, they are backed by the financial strength of the insurance company. That makes it imperative that you select an annuity from a company that’s financially sound.

Beyond that, annuities tend to be somewhat expensive with high commissions, mortality and expense risk fees and surrender charges, depending on what type of annuity you purchase. Make sure you fully understand the terms of the contract and your alternatives before buying. Finally, these fixed insurance products normally offer mediocre rates of return, at least compared to some of their riskier counterparts.

Fixed vs. Variable Annuities

Generally speaking, fixed annuities are less risky than variable annuities. Fixed annuities offer a constant interest rate, though there is some fluctuation in your rates over time. In turn, market volatility or company profits don’t directly affect the interest rate on the contract.

However, like all investments, since fixed annuities are less risky than variable annuities, they tend to have less return potential. With variable annuities, you can invest in a variety of investment funds, that contain a multitude of stocks and bonds to achieve your desired return. That means the stock market tends to impact a variable annuity’s value more than a fixed contract. Policyholders should select investments that coincide with their risk tolerance and time horizon with a variable annuity.

For conservative investors who seek stability and safety, a fixed annuity might be a better option. Knowing that your returns will barely fluctuate may put a conservative investor’s mind at ease. For investors who have longer time horizons and are comfortable with market volatility, variable annuities may be the right choice. They tend to keep pace with inflation and help investors reap higher gains over the longevity of the contract.

Bottom Line

Fixed Deferred Annuity

A fixed deferred annuity could be an attractive option for investors who want the benefits of an annuity, but who don’t need the income today. Because these accounts invest in low-risk assets, they can be suitable for investors who want guaranteed income without the volatility of the stock market. When the annuity matures, the account holder has multiple options for their account, including letting the account continue to grow tax-deferred.

Retirement Tips

  • There are many types of annuities that fit different investor needs. Working with a financial advisor can make this decision process much easier. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Utilizing a fixed deferred annuity in your retirement plan allows you to contribute money over time. SmartAsset’s investment calculator projects the growth of your account assuming expected rates of return. You can personalize the results based on your starting balance, contributions and timeframe.

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