Understanding the Fixed Annuity Basics

A fixed annuity is an insurance contract with a future promise to pay income. It is based on the life of an individual, known as the annuitant. The annuitant is the same as the insured in a life insurance contract. A payment or series of payments accumulates in the annuity until such time that it is received as income.

Fixed annuities that pay income after the initial payment is received with one year’s time are called single pay immediate annuities. An annuity that receives a series of payments and pays it in the future is a fixed deferred annuity. Fixed annuities have a guaranteed interest rate that is set by the insurer based on an underlying bond index.

Because these annuities are backed by the guarantees of the insurer, their rate of return is lower than a comparable Variable Annuities. Variable Annuities are investment products that pass the return’s risk to the annuity owner. The potential for higher returns is offset by the risk of losing value. This is not the case with a fixed annuity since the insurer must provide the return.

When money is deposited into an annuity and grows with interest this is called the accumulation phase. During this period, taxes are deferred on the interest building up inside the contract. When the annuity owner decides to take an income distribution, the contract is annuitized. This payout of income takes place immediately or over years based on one or more lives.

You should not compare the returns received in an annuity with that of a mutual fund. A fixed annuity has certain fees and charges that are not found in investment products. These fees and charges encourage the owner to keep the money in the product for a period of time. Fixed Annuities are not subject to market or investment risk as mutual funds are. The only real risk would be insolvency of the insurer, which rarely occurs.

To receive the tax advantage of an annuity, an owner should be prepared to leave the money until close to age 60. Distributions of income prior to age 59 and a half result in taxes and penalty fees. Insurance companies also use surrender charges as a way to discourage premature distributions. Other than, for special purposes surrender charges last for up to 20 years at rates up to 30 percent. This makes fixed annuities idea tools for long-term goals such as retirement. The high fees and potential penalties levied also distinguish annuities from investment products.

Individuals receiving a large inheritance or lottery winning may use a special type of Fixed Annuity. These are known as structured settlement annuities and help to distribute income from large payments evenly over time. The rates on most fixed annuities tend to be higher than a standard bank CD. A true comparison of the two should also look at fee structures and expenses as well.

Purchasing a Fixed Annuity may be an appropriate decision for most individuals. Meeting some future needs such as retirement while reducing the potential downturns in the market make them idea. You should consult with a licensed professional for more information about a fixed annuity.