What Is a Fixed Annuity?
Traditionally, Fixed Annuities have been seen as a relatively low risk to higher return investment compared to Certificate of Deposits (CDs) offered by banks and credit unions. For decades, fixed annuities have been used to provide a secure form of asset protection for millions of investors looking for a conservative tax-deferred option. Considered the simplest type of annuity contract. Fixed Annuities provide all the benefits offered from the annuity class of assets without worrying about ups and downs in the securities markets.
To understand the benefit that a fixed annuity can provide to your portfolio this article will describe some details and terms of this asset.
How are Fixed Annuities different?
Depending on the type of fixed annuity contract normally purchased from an insurance company, the annuity is bought either through a lump sum payment or a defined series of payments. As written into the annuity, the owner will be entitled to a guaranteed interest rate for the period defined in the contract. Comparable to a CD, the owner is guaranteed a defined principle and interest earning and there are penalties for cashing out early. There are tax benefits for using annuities toward retirement, as the earnings are not taxable while saving.
Some History of Fixed Annuities
Fixed annuities are the simplest and oldest form of annuity contract. The earliest known annuities began with Caesar in the ancient Roman period. Also, both the Babylonians and Egyptians had contracts guaranteeing periodic payments. During the middle ages in Europe, Annuities were used as a way to get around the religious bans against usury – the charging of interest. The first true U.S. insurance company was chartered in Pennsylvania in 1794. Since that time there are now hundreds of companies that sell this product.
Basic’s on Contract Terms and Rates of Fixed Annuities
Especially when compared to CDs, Fixed Annuities provide the following features:
- Deferred Taxes on earnings
- Personalized payout options
- In most cases, higher rate of interest compared to Certificates of Deposit
- Survivor benefits and probate exemption
- Protection from creditors
- Guaranteed Returns well into the future
- In most cases, they will automatically renew at a revised interest rate unless you withdraw or move the money.
- In many fixed annuities, a Cost of Living Adjustment (COLA) can raise the return every year until maturity.
This is why many smart investors will purchase annuity contracts as part of their portfolio.
Fixed Annuity Payout Clauses
The most common Fixed Annuity contracts will have the following payout clauses or Riders to choose from, including:
- Straight life. Specified dollar amounts tied to actuarial tables that will disperse funds for the rest of your life. Even if the total payout exceeds the value of original contributions plus growth. A caveat of this payment option is that the payouts will cease at death, even if the total payments made are less than the value of your original investment made.
- Joint life. A popular option for married couples whereby you and your co-beneficiary receive payments as long as one of the two of you is living.
- Life with Period Certain. A payment plan that will continue to provide income for as long as you live or over a set amount of time. This precludes the insurance company from gaining the remaining balance of payments if you die prior to obtaining the full contract value.
- Joint Life with Period Certain. Similar to the previous plan. Applies the same protection for payouts as long as you or your co-beneficiary are living, or over a predefined period of time.
- Systematic Withdrawal. A specified value of the dollar amount or sprecified percentage of the contract value to be paid out every year.
- Lump Sum. A single payment made on a specified date that cashes out the contract upon maturity.
Fixed Annuities and Taxes
For many people planning for retirement Fixed Annuities are a great choice. For those who wait until after they are 59 ½ to withdraw funds, the money you invest in a fixed income annuity contract will appreciate on a tax-deferred basis, as long as disbursements are not made. Once payments begin the IRS will tax your earnings the same as any other form of income. Disclosed in the 1099-R portion of your tax returns. As such, using the exclusion ration, you will be able to withdraw your principle tax free but growth is taxed.
If, for example, you invest $100,000 in a fixed annuity contract and it doubles to $200,000 and as a result your monthly payments are $1,000, the exclusion ratio dictates that 50% of every disbursement ($500) will be considered a tax-free return of principal when calculating your taxable income.
Are Fixed Annuities Safe?
Fixed Annuities are contracts between you and an insurance company. As such the risk is tied to the strength of the insurance company. Major rating agencies like Standard and Poor’s, Moody’s, Fitch etc. offer grades to the strength of insurance companies. These are designated as AAA or AA, for example. The lesser the strength of the insurance company the lower grade it will receive.
State laws have been established that govern requirements the insurance companies must fulfill to offer this product to the public. In general, insurance companies are required to maintain a cash reserve that is, at a minimum, equal to the total value of all outstanding fixed annuity contracts. This is meant to provide a strong level of security to annuity holders that the insurance company will be able to fulfill its contractual obligations with annuity holders even in negative financial markets. Also, insurance companies themselves have policies with reincurance companies to further protect from unforeseen circumstances. The reinsurance company will be required to step in and pay out annuity contracts in the event that an insurance company goes bankrupt. Thus, even though fixed annuities are not FDIC insured, these contracts are considered very safe investments since your chances of losing your money is very low.
Due to the low risk of these products it is a favorite of older investors and people who do not want to have to worry about losing money. Wealthy investors will allocate a portion into annuities to protect a portion of their wealth from market risks. Fixed annuities are ideal for investors who are looking for a secure product that will appreciate at a specified rate.
Fixed annuities have been around for a long time. They are considered a low risk, highly secured, and guaranteed form of income. Annuities are popular since they will normally outperform US Treasuries and CDs offered by banks. They also offer important tax benefits to many investors.
If you would like to know more about annuities please contact us, or speak to your financial advisor.