A fixed annuity is an investment product issued by insurance companies that is most like a certificate of deposit, CD, issued by a bank. Fixed annuities provide regular and consistent interest payments in exchange for investor deposits. However, whereas CDs are guaranteed by are guaranteed by federal insurance, the guarantee backing annuity payments are only as strong as the financial strength of the underlying insurance company.
Deferred Annuities
A deferred annuity does not pay you any interest until the end of an accumulation period, during which your contributions grow at a specified earnings rate. Accumulation periods often last 10 years or longer, after which your annuity switches to the annuitization phase, in which payouts commence.
Immediate Annuities
With immediate annuities, there is no accumulation phase, and your contributions immediately switch to the annuitization phase.
Life Annuities
The types of life annuities are numerous, but the feature they all share is that they will pay you fixed interest payments for the duration of your lifetime. With a straight life annuity, payments will cease upon your death, regardless of whether you have been receiving payments for 20 years or one day. As the length of time you will live can never be determined with certainty, life annuities carry an insurance component, which ensures that there will be money available regardless of how long you live. Life annuities can be modified to provide additional features, such as available payments for beneficiaries or joint ownership provisions, but each modification comes at a higher cost.
Term Certain Annuities
A term certain annuity will pay you interest for a specified time period, after which all payments will cease. Term certain annuities have no insurance component, as life annuities do, which makes term certain annuities less expensive.
Taxation
Annuities are tax-advantaged investment products, so you do not have to pay income tax during the accumulation phase of your annuity. However, distributions from your annuity are partially taxable. The portion of your interest payments that are a return of your originally invested capital are tax-free, but the earnings on your annuity contract are taxable at ordinary income tax rates.
Fees
Most fixed annuities carry a variety of fees and expenses, from to cost of insurance to surrender fees to miscellaneous charges known as mortality and expense charges. Generally, an insurance company will charge you a fee if you redeem or sell your contract in the first seven to 10 years after purchase. Fees can range as high as 7 percent for a surrender during the first year, with the amount of the fee declining the longer you hold your contract. Other internal expenses can amount to more than 1.5 percent per year.
IRS Penalties
As a fixed annuity is a tax-advantaged investment account, the Internal Revenue Service will charge you an early withdrawal penalty of 10 percent if you withdraw any funds before the age of 59 1/2. This penalty is in addition to ordinary income tax and any insurance company penalties.
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