What is a Fixed Annuity?
A fixed annuity is an insurance product designed to provide investors with principal protection, a fixed rate of interest, and tax-deferred growth. It is most appropriate for investors aged 59 ½ or more, due to the fact that a 10% IRS penalty may apply to growth that is “cashed out” before age 59 ½. Please note that the guarantees of a fixed annuity are subject to the claims-paying ability of the insurance company. Therefore, for investors interested in fixed annuities, it’s important to review the financial condition of the insurance company before investing.
When might I consider owning a fixed annuity?
Each client’s situation is unique, but one particular scenario may seem especially well-suited for owning a fixed annuity. At Calder & Colegrove, we encourage clients who are near or in retirement, to maintain a healthy emergency fund. And we define an emergency fund as assets that are both liquid and guaranteed. In our opinion, FDIC guaranteed accounts, such as checking, savings, and money market, are ideal sources for emergency fund holdings. However, clients have sometimes expressed dissatisfaction with the interest they receive from these accounts.
With this in mind, we believe that a fixed annuity may make sense for assets above and beyond what a client holds in their emergency fund. Consider this scenario: Jane holds $100,000 in FDIC guaranteed assets. She states that she would like to earn a better interest rate. But Jane indicates that she does not wish to take any stock market risk with these assets. After discussing her needs, we determine that maintaining $50,000 through her FDIC guaranteed accounts makes sense. And therefore, for the remainder, we recommended a $50,000 fixed annuity, for the three-fold purpose of principal protection, a fixed rate of interest, and tax-deferred growth.
Are there any tax advantages to owning a fixed annuity?
The interest earned in a fixed annuity is compounded and tax-deferred. As an example, let’s revisit Jane for a moment. Let’s say that Jane purchased a $50,000 fixed annuity with a 5-year maturity, and the contract provided for a 3% fixed rate of interest. After one year, her balance would be $51,500 ($50,000 + 3%). After two years, her balance would be $53,045. That’s because a fixed annuity provides compound interest, as opposed to simple interest. Skipping ahead: At the end of five years, her annuity would equal $57,963.70. In terms of taxes, normally, when an investor enjoys gains on an investment, those gains are subject to taxes. But if the account type is some type of tax-favored investment, such as a 401k or IRA, then those taxable gains are deferred until later. This is described as tax-deferred growth. This is also the case with a fixed annuity. The interest earned on a fixed annuity is deferred so long as the interest remains in the annuity. Once an investor withdraws the interest, then the taxes on that interest are due.
What if I don’t need the money when it matures?
When a fixed annuity matures, an investor has three choices:
- 1. Cash Out: Simply put, this means that an investor cashes out the annuity and receives their principal, plus interest. Interest earned is subject to taxes at this point.
- 2. Renew: Alternatively, you can renew your annuity, with the same insurance carrier, for a new period. Through renewal, gains in the annuity continue to be tax deferred, until withdrawal.
- 3. 1035 Exchange: Lastly, perhaps the current annuity carrier doesn’t offer the best interest rate available in the market place. In that case, an annuity can be transferred to a new insurance carrier through a 1035 exchange. And similar to renewing your annuity, a 1035 exchange continues the tax-deferred nature of the interest earned.
When might it be a bad idea to buy a fixed annuity?
We believe the decision to buy or not buy a fixed annuity comes down to the need for liquidity. Because, if a client needs more liquidity, a fixed annuity may not a suitable investment. Although a fixed annuity may provide a higher interest rate as compared to some FDIC products, the liquidity provisions of fixed annuities are limited. As an example, some fixed annuity products provide a 10% annual withdrawal of principal, free of any surrender costs, after one year of ownership. Therefore, if a client needed access to more than 10% in any given year, surrender costs may be imposed by the insurance company. Additionally, if an investor is under age 59 ½ at the time of purchase, and the maturity of the annuity is also scheduled to occur before the investor reaches age 59 ½, we do not recommend the use of a fixed annuity. This is due to the fact that the interest earned may be subject to a 10% IRS penalty upon distribution.
What happens to my fixed annuity if I die or become disabled?
Although each contract is different, it’s commonplace for insurance carriers to provide a 100% distribution, free of surrender costs, in the event that the contract owner passes away. Additionally, there are provisions with some insurance carriers, that provide surrender-free access to the fixed annuity due to qualifying long-term care events. Each contract, however, is unique.
Comparing a CD to a Fixed Annuity
Through many custodians, such as banks, an alternative to fixed annuities is found through a Certificate of Deposit (CD). Like a fixed annuity, a CD may also provide a higher rate of interest in comparison to checking, savings, and money market accounts. And if liquidity is a concern, a CD may be a better choice than a fixed annuity. For a side-by-side comparison of a CD and fixed annuity, see below:
|Principal Protection||Yes – Backed by FDIC||Yes – backed by claims-paying
ability of Insurance Carrier
|Interest Type||Simple Interest||Compound Interest|
|Liquidity||More Liquid||Less Liquid|
The decision to buy or not buy a fixed annuity is not easy to self-determine. Seeking the advice of a trusted financial professional is warranted. And we believe that it’s in a client’s best interest to work with a professional who takes a look at the holistic view of a prospective investor before making any recommendations. If you want to find out personally, if a fixed annuity might have a place in your portfolio, please contact our office.
CDs are FDIC insured to specific limits and offer a fixed rate of return if held to maturity. Annuities are not FDIC insured. Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Withdrawals made prior to age 59 ½ are subject to 10% IRS penalty tax. Surrender charges apply. Guarantees are based on the claims paying ability of the issuing insurance company.