The Pros and Cons of Fixed Annuities
In This Article
Fixed annuities offer guaranteed returns through monthly payments once you retire. Of course, before choosing any financial product to meet your retirement goals, it's essential to consider the pros and cons. A fixed annuity can be a great way to fund retirement, but you'll also want to consider tax obligations and associated fees. Learn what a fixed annuity is, who can benefit most from one, and a few key considerations as you decide if this is the right financial tool for you.
What Is a Fixed Annuity?
A fixed annuity is a retirement tool that allows you to purchase a contract from an insurance company. This contract provides you with a fixed interest rate on your contributions once it matures. The interest rate refers to the percentage of returns you’ll receive on your contribution. Fixed annuities provide guaranteed income for the rest of the annuitant's life. You’ll receive a lump sum or monthly income payment at the end of your fixed annuity contract. These fixed annuity contracts typically include a minimum rate guarantee.
Fixed Annuity vs. Variable Annuity
A fixed annuity differs from a variable annuity in that it promises a guaranteed interest rate. A variable annuity offers returns based on market performance. The financial strength and claims-paying ability of the issuing insurance company ensure the safety of fixed annuities. While a variable annuity could pay out more if the market performs well, it could also lead to higher losses. The reduced risk of a fixed annuity makes it an appealing option for those looking for guaranteed returns.
Who Should Invest in Fixed Annuities for Retirement Income?
Fixed annuities are excellent for those wanting steady, guaranteed retirement income. A deferred fixed annuity is suitable for those planning for retirement with a waiting period before income withdrawals begin. This may include investors looking to offset other higher-risk products or those nearing retirement with a lower risk tolerance.
It’s also important to be aware of the investing requirements of a fixed annuity when determining who should choose one. A fixed annuity typically requires an investment between two to 10 years. This means fixed annuities are ideal for people with a minimum of $10,000 to leave in an account for the accumulation period. Fixed annuities offer tax-deferred growth, which can be beneficial for long-term retirement planning.
Pros of Fixed Annuities: Guaranteed Interest Rate
Here are some of the pros of fixed annuities:
Guaranteed returns: Fixed annuities offer guaranteed returns, making them an excellent option for risk management as you near retirement age. This is one of the key benefits of a fixed annuity, providing financial stability and peace of mind.
Guaranteed minimum interest rate: Some fixed annuities offer a guaranteed minimum interest rate for the entire contract term, ensuring a stable return even if market conditions change.
Guaranteed income payments during retirement: Contributing to a fixed annuity allows you to collect guaranteed income payments once you retire. These payments can be structured for a set period or for the rest of your life, making it easier to plan for retirement expenses.
Tax-deferred: Contributing to a fixed annuity allows you to defer tax obligations until you withdraw the funds. Many people will be in a lower tax bracket after retirement, which can also lead to fewer taxes paid.
Protection from market volatility: The market can be highly volatile. A fixed annuity can protect you from this since returns are based on a set rate, not market performance.
Low contribution requirements: The minimum requirement for an annuity is usually $10,000. Some annuity providers may offer mini-annuities with even lower entry requirements. You may also be able to pay monthly premiums to meet the contribution requirements during the accumulation phase of a fixed annuity.
Fixed annuities are relatively easy to understand. Most fixed annuities include a contract with a set period and a specific rate of return.
Cons of Fixed Annuities: Ordinary Income Tax
Here are a few crucial considerations of fixed annuities:
Illiquid: Annuities often charge surrender or early withdrawal penalties, so they’re usually considered illiquid. It’s best to fund an annuity with money you don’t plan on using for a few years. Withdrawing your money before 59.5 years may also subject you to tax penalties. Early withdrawals can impact the account value and may incur surrender charges.
Limited returns: Fixed annuities may not pay as high of interest rates as variable annuities. However, they carry less risk since you’re guaranteed a set rate of return. Compared to certificates of deposits (CDs), fixed annuities usually offer a higher rate.
Expensive fees: Some annuity funds charge high administrative costs and commissions, which can reduce your returns. Ensure you understand all fees associated with an annuity contract before agreeing.
Inflation: A fixed annuity pays you a fixed rate once your policy matures, which may not account for inflation. The cost of living steadily increases over time, which could lead to your annuity payments being valued less than expected.
No step-up in basis: Annuities don’t offer a step-up in basis, which means your beneficiaries will owe taxes on all earnings.
Limited protections: Unlike banking institutions, the federal government doesn’t regulate annuities. However, many states have guaranty associations that provide some annuities protection.
Withdrawals from fixed annuities are subject to ordinary income tax.
Evaluating the financial strength of the issuing insurance company is crucial, as it guarantees payouts and addresses potential risks associated with fixed annuities.
Choosing a reputable annuity provider is one of the best ways to avoid high fees. Determining where your fixed annuity fits in with your retirement plans can also help with illiquidity and planning for inflation.
Fixed annuities are a stable retirement product that provides you with guaranteed returns. Consulting with a financial adviser can help determine if a fixed annuity will help you reach your retirement goals.
