Fixed-rate annuities are popular because of their guarantees, simplicity and higher rates than most competing products.
A fixed-rate annuity — also known as a multi-year guaranteed annuity — acts much like a bank certificate of deposit (CD). There’s a set interest rate for a set period. For example, a seven-year fixed annuity from one company was offering a guaranteed annual yield of 3.50% for seven years as of June 2020.
There are some key differences. CD interest is taxable annually, unless the CD is in an IRA or other qualified account. Annuity interest is tax-deferred until withdrawn. This lets your money compound faster over time.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
With so many annuities available today, it’s important to choose the one that is right for you and your specific needs. Although fixed annuities are straightforward, there are differences in the interest rates, length of the guaranteed rate periods, and the ability to make withdrawals.
Here are some of the important questions to ask before purchasing a fixed annuity.
Does the annuity have a pre-set and guaranteed interest rate for the entire guarantee period?
Most fixed-rate annuities have a guaranteed interest rate for the entire guarantee period, but with some products, the rate may change after an initial period. For example, the annuity may offer a higher interest rate for the first year and then a lower rate for the remainder of the guarantee period.
If the rate can change, be sure that you know how soon it can change and what the new rate will or could be.
While having a fixed rate for the entire period is an advantage, sometimes a fixed annuity with a rate that later becomes adjustable can be a good deal. It just depends on how the contract is structured.
How strong is the company that insures this annuity?
Unlike bank deposits, annuities are not FDIC insured. However, there is a form of insurance provided by state guaranty associations in case the insurer becomes insolvent. Coverage varies by state.
Annuities are guaranteed by the issuing insurance company. Therefore, it is important to check the insurer's ratings provided by agencies such as A.M. Best, Standard & Poor's or Moody's. These agencies grade insurers for their overall financial strength and their claims-paying ability.
Be sure that the insurance company you go with is financially stable, as you will want it to be there in the future when you need it.
Are withdrawals permitted during the term of the annuity? If so, how much is allowed?
Nearly all fixed annuities let you withdraw a certain percentage of your total account value or your initial premium each policy year. Typically, account holders may withdraw up to 10% of their principal each year without penalty. However, withdrawals before you reach age 59½ may be subject to an IRS penalty of 10% of the earnings that are withdrawn, plus ordinary income tax.
Therefore, it is not generally advisable to purchase a deferred annuity if you will need either access to your funds or to make withdrawals prior to age 59½.
How does the interest compound?
Annuity interest compounds annually unless you withdraw it. Not taking withdrawals will allow your funds to produce more interest each year of the contract. For example, if you purchased a $100,000 annuity that guaranteed a 3.50% interest rate for 10-years and withdrew your $3,500 in interest earnings each year, at the end of 10 years you will have collected $35,000 in total interest. By contrast, if you allowed your interest earnings to remain in the annuity and compound each year, at the end of the 10-year period your annuity value will have grown to $141,060, giving you over $6,000 more in total interest earned as compared to annual withdrawals.
How is the growth on your funds inside the annuity taxed?
The interest credited to your annuity will grow tax-deferred until it’s withdrawn. The money inside the account continues growing without taxes, allowing your funds the opportunity to compound exponentially over time.
This can be a distinct advantage over the funds inside of a bank CD not held within an IRA or qualified account, as the interest that is earned on a CD is taxed each year. So, for instance, if you’re earning 1.80% on a five-year CD and you’re paying 25% in federal and state income taxes, you’d net a mere 1.35% annually after taxes.
With an annuity, your funds will compound at the full quoted rate because you’re delaying taxes. You or your heirs will owe tax on the gain eventually, but delaying the tax bite means more money in your pocket in the long run.
Are there any fees associated with a fixed annuity?
There are no upfront sales charges or ongoing maintenance fees. All of your money goes to work for you.
Surrender charges will only occur if you withdraw more than the allowed amount during the surrender period. So, be sure that you won’t need most of the money you deposit until the period is over.
What happens to your funds in the annuity if you pass away prematurely?
If you die before you have gotten back all of the money that you deposited in the annuity including any accumulated interest earnings, your named beneficiary will receive the amount remaining in the annuity. On the vast majority of deferred annuities (not yet annuitized) the insurance company keeps nothing. There is a waiver of surrender charges upon death and the beneficiaries receive the full remaining accumulation value. If your beneficiary is your spouse and you haven’t taken any withdrawals, he or she will inherit the entire annuity and will typically have the option of assuming ownership, which would continue the policy’s tax-deferred status and avoid any immediate taxation. (For more on that, see Inheriting an Annuity, Here’s a Little-Known Way to Stretch Its Tax Benefits.)
What are your choices when the initial guarantee period is up?
There’s a lot of flexibility. You can take all the money in cash and pay income tax on the gain, but most people don’t do that.
To continue to defer taxes, you can renew for an additional term or use the funds to buy another annuity from the same or a different insurer via a 1035 exchange. When transferring to a new annuity, you can choose any type of annuity you want, such as a fixed-indexed or variable annuity.
You also can choose to annuitize the proceeds. This means you convert the fixed annuity into a stream of guaranteed lifetime monthly income that begins immediately or, with a deferred income annuity, on a future date you choose.
-
Think a Repeal of the Estate Tax Wouldn't Affect You? WrongThe wording of any law that repeals or otherwise changes the federal estate tax could have an impact on all of us. Here's what you need to know, courtesy of an estate planning and tax attorney.
-
In Your 50s? We Need to Talk About Long-Term CareMany people don't like thinking about long-term care, but most people will need it. This financial professional recommends planning for these costs as early as possible to avoid stress later.
-
Social Security Pop Quiz: Are You Among the 89% of Americans Who'd Fail?Shockingly few people have any clue what their Social Security benefits could be. This financial adviser notes it's essential to understand that info and when it might be best to access your benefits.
-
Two Estate Planning Issues You Should Never OverlookThis estate planning attorney explains why proper asset titling and beneficiary designations make a big difference when it's time to transfer your wealth.
-
The Three Retirement Tax Issues I Nag My Clients AboutA financial professional highlights areas of tax planning that retirees should have on their radar as they finalize their retirement plan.
-
How to Turn Education Planning Into Retirement PlanningNervous about investing in a 529 plan? If college doesn't pan out, the money can now be rolled over into a Roth IRA, which will grow tax-free until retirement.
-
How Financial Advisers Can Help Clients Navigate the SSFAThe Social Security Fairness Act's big changes and new opportunities could require adjustments in tax strategy for some Social Security recipients.
-
My Five-Step Estate Planning Guide to Protect Your FamilyA wealth adviser notes that an estate plan that covers everything from guardianship to digital assets and taxes — and is discussed openly — will give you and your family peace of mind.
