The takeaway: Fixed annuities are like CDs, except you earn a higher rate. Even better, your interest grows tax deferred. But there are steep penalties for early withdrawal. And tax treatment isn’t particularly favorable to your heirs. Look before you leap.
Part six in a series on annuities that will appear here from time to time.
When I was about 7, I was obsessed to find the money for a Toni doll. The Barbie doll hadn’t hit the scene yet. When I was with my mom and see a toy I wanted, she’d ask if I wanted that toy, or, did I want to put that money toward the Toni doll.
Toni it was.
I still remember walking in the store with my jar of coins and buying that doll.
Inexplicably, I have zero memory of ever playing with that doll.
Buying a fixed annuity is a lot like buying a Toni. You save up, buy it, and forget it.
Fixed annuities: like buying a CD (or Toni).
Finding my Toni analogy lacking, the finance industry compares buying a fixed annuity to buying a certificate of deposit (CD). (They never knew Toni.) You buy a fixed annuity by surrendering your money for a select number of years Then you get it back with interest–just like when you buy a CD.
However, unlike with CDs, fixed annuities generally pay higher interest rates. At press, a five-year CD paid roughly 1% interest, while a fixed annuity with the same term paid about 3%. You don’t pay taxes on the interest earned until you start collecting on the annuity—an advantage we’ll discuss shortly.
You can choose from two types of fixed annuity contracts.
Your choices are:
- a Multi-Year Guaranteed Annuity contract (MYGA), which is bought with a lump sum and has a guaranteed interest rate for the life of the annuity;
- a single-year fixed annuity contract, which can be bought with installment payments and has an interest rate that changes each year.
Since you assume more risk with the latter, i.e., the single-year fixed annuity contract, annuity firms add some incentives to sweeten the pie. These include:
- a relatively high introductory interest rate,
- a guaranteed rate at which your interest will fall no further, and
- a bonus, which is a lump sum of money the firm adds to your annuity and is redeemed when the annuity matures.
Regardless of the type of contract you buy, how much interest you’re paid depends on:
- how much money you put into the annuity and
- how many years you hold the annuity.
Generally, the bigger the annuity and the longer you hold it, the more money you make. Most fixed annuities are held from two to seven years.
Why might you buy a fixed annuity?
You might buy because:
- you want a stable fixed-rate investment that will complement the high volatility and high returns of the stock funds you already own;
- you’ve maxed out your traditional IRA, and 401(k), and want to continue deferring your taxes.
When a fixed annuity matures, you can roll it into a longevity annuity, deferring taxes even further, if tax deferral is your goal.
What are the advantages of buying a fixed annuity?
The four primary advantages are:
- Interest accumulates tax deferred and pays a higher rate than competing investments, like CDs.
- Compared to other annuities, fixed annuities pay low fees and low commissions.
- Contributions are unlimited.
- If you exit stage left, the annuity avoids probate.
Interest accumulates tax deferred and pays a higher rate than competing investments.
Since your interest accumulates tax deferred, you don’t pay any taxes on the interest earned until the annuity matures. This allows your money to grow faster over time, than it would with, say, a CD. This is because your annuity interest compounds uninterrupted by reductions from paying yearly taxes.
Moreover, as noted earlier, fixed annuities generally pay higher rates than competing investments like CDs.
Compared to other annuities, fixed annuities have low fees and commissions.
As shown here and here, fixed rate annuities have the lowest fees and pay sales agents relatively low commissions. As a result, they’re not typically marketed with the exuberance of variable and equity-indexed annuities, which are lucrative to the annuity firm and sales agent, but not necessarily to you.
Contributions are unlimited.
Compared to employer sponsored retirement plans — whose limits are $64,500, and Individual Retirement Accounts, whose limits are $7,000 — you can deposit as much as you can afford in a fixed-annuity. (The preceding limits are quoted for those over 50.)
If you exit stage left, the annuity avoids probate.
When you exit stage left, your annuity is not considered part of your estate. As such, it’s not subject to your creditors or anyone else claiming access to it. It simply goes directly to your beneficiaries.
What are the disadvantages of a fixed annuity?
There four main disadvantages of fixed annuities.
- There are steep penalties for early withdrawal.
- They provide no inflation protection.;
- Upon inheritance, your heirs incur unfavorable tax treatment.
- In rare instances, annuity firms have gone bankrupt (just ask me).
Steep penalties for early withdrawal.
Although fixed annuities generally allow you to withdraw 10% of the value of your annuity each year without penalty, any additional withdrawals are subject to surrender charges. Surrender charges typically start at 10%, then reduce by 1% each year, as shown below.
Figure 1. The fewer years you hold the annuity, the more money you lose, due to higher surrender penalties.
Source: Annuity Surrender Periods: Understand (and Avoid) Surrender Charges, The Balance, January 31, 2021.
No inflation protection.
During the life of your annuity, interest rates on the on the open market may increase. Unlucky for you, your annuity’s interest rate won’t change beyond what is in your contract. Consequently, the annuity company will be paying new customers higher interest rates than they’re paying you.
Even if the annuity firm offers to let you exchange the annuity for one with more favorable interest rates, via a 1035 exchange, you’ll still barely benefit. Generally, you’re still subject to surrender charges with your current annuity. Plus, you’ll be liable for surrender charges on the second one as well.
Unfavorable tax treatment to your heirs.
When your heirs inherit an annuity that’s appreciated in value, they’re obligated to pay income tax on the appreciated amount. Hence, if you bought the annuity for $100,000, and at your exit it’s worth $150,000, heirs have to pay ordinary income tax on the $50,000 appreciation. Ordinary income tax ranges from 10% to 37% percent, depending on your bracket.
Generally, your heirs would have ended up with more money if you’d simply left them stocks, bonds, mutual funds, and real estate. If those assets had been purchased at $100,000, and appreciated another $50,000, your heirs could sell the assets upon receipt and owe no taxes. (!) This is called a “step-up provision.” You lovable overachievers can read all about it and watch the video here.
Remember, always check with a tax professional skilled in annuity tax law.
In rare instances, annuity firms have gone bankrupt.
Although it doesn’t happen often, annuity firms have gone bankrupt from time to time. Read the post here. And don’t let what happened to me happen to you! You can seek redress from your state’s guaranty fund if the worst happens. Residency requirements apply.
If the worst hasn’t happened and you want out before it does, read this post about getting about of a bad annuity.
Fixed-annuities: a stable corner in your portfolio
If you don’t mind the risks associated with handing your money over to a company for two to seven years, fixed annuities can provide a portion of your portfolio that’s immune from the natural and expected fluctuations in the stock market. With these annuities, you save up, buy it, and forget it.
Just like with Toni.
Extra extra! Read all about it!
- BluePrintIncome.com. Fixed Annuities: A Safe, Guaranteed, and Tax-Deferred Way to Grow Your Retirement Savings,
- BluePrintIncome.com. Fixed Annuities: A Safe Guide in Plain English.
- Pechter, Kerry. Annuities for Dummies, 2008.