A fixed annuity is an annuity wherein the issuer (usually an insurance company) guarantees both the interest rate paid on invested dollars and the return of principal.
What is a fixed annuity?
A fixed annuity is an annuity wherein the issuer (usually an insurance company) guarantees both the interest rate paid on invested dollars and the return of principal. The issuer guarantees that a minimum rate of interest will be paid on the annuity, but the actual rate of interest credited to the annuity is typically higher than the guaranteed rate.
Interest rates may be low on fixed annuities
Interest rates paid on fixed annuities are subject to the current interest rate environment. During periods of low interest rates (some periods can go on for many years), the interest rates for an annuity can be low and remain low for quite some time. Low interest rates could impact the potential growth of your annuity. However low the interest rate environment goes, the annuity cannot pay less than its guaranteed minimum rate.
When should you buy a fixed annuity?
A fixed annuity may be an excellent vehicle for individuals who want the benefits of tax-deferred earnings. The earnings on a fixed annuity (as with other types of annuities) are not subject to income tax until they are distributed. Thus, your annuity premiums and earnings may compound tax deferred for many years.
A fixed annuity may also be a good investment for an individual who is a conservative investor. Because the annuity issuer promises to pay you a minimum rate of interest on the money invested in the annuity, there is little downside risk to a fixed annuity. With a fixed annuity, you know right at the beginning the minimum rate of return you may earn on your fixed annuity. A risk you run with a fixed annuity is if the issuer has financial problems and becomes insolvent. In this case, it may not be able to continue to credit interest to your annuity or return the money you have invested in the annuity. Historically, there have been very few defaults on annuity contracts by insurance companies and other annuity issuers. Therefore, if you have a conservative investment outlook, buying a fixed annuity may be a good choice.
Caution: Guarantees are subject to the claims-paying ability of the annuity issuer.
Annuities tend to be good investments only for individuals who are investing money for the long term. One of the tradeoffs to the purchase of an annuity is that the insurance company will usually let you withdraw in the early years only a small percentage (10 percent, usually) of the money you have invested in the annuity without a penalty. If you want to withdraw more than this percentage each year, the annuity issuer will typically charge you a surrender charge.
Finally, if you withdraw money before the age of 59½, the tax code tacks a penalty of 10 percent onto the withdrawal. There are some very limited exceptions to this early withdrawal penalty tax. Between the surrender charge, the potential income tax liability, and the early withdrawal penalty tax, a substantial part of your investment may be eaten up if you make an early withdrawal from the annuity. Thus, an annuity is usually a good investment only for people who can afford to keep their money in the annuity for a period of 10-15 years and who will not begin withdrawals until after the age of 59½.