What Is the Difference Between Fixed, Fixed-Indexed, and Variable Annuities?
Categories: Annuity Education, Annuity Strategies, Fixed Annuities, Indexed Annuities
There are several types of annuities that you should be aware of while trying to choose a vehicle for your retirement funds. Annuities can be immediate or deferred and they can provide fixed or variable returns.
In this article, we’re discussing the differences between fixed, fixed-index, and variable annuities. Fixed and variable annuities can either be immediate or deferred. For more information on the difference between immediate and deferred annuities, you can visit our articles that explain more about these two categories of annuities by clicking the embedded links below.
If you’re interested in the different types of annuities and how you can better prepare for or implement your retirement plan, continue reading. Additionally, if you’re interested in consulting a professional about the potential for annuities in your retirement plan, AnnuityAdvantage has been guiding people to the annuity that fits their retirement needs for over 25 years and we can help to ensure you understand all of the specifics about your annuity before making a decision.
What Are Annuities?
Annuities describe contracts with insurance companies where you make premium payments in exchange for a fixed interest rate, a variable return or an immediate or future stream of guaranteed income. The funds in a deferred annuity accumulate on a tax-deferred basis regardless of the type of product you select. Because you don’t have taxes to pay on the growth in your annuity contract until withdrawn, annuities have become a popular way to accumulate funds for retirement.
What Is a Fixed-rate Annuity?
Fixed-rate annuities, also known as multi-year guarantee annuities (MYGA), describe insurance-based contracts typically funded with a lump sum premium payment. In exchange for the payment you make, insurance companies will credit your contract with an interest rate that is guaranteed for a pre-determined period of time, typically 2 to 10 years.
At the end of the initial guarantee period, you can cash out your annuity, renew it for another term, or exchange it for a better offering from another insurance company via a 1035 exchange. Fixed-rate annuities have guaranteed-minimum interest rates specified in their contracts. Though your rates can adjust after the initial guarantee period has ended, it will never fall below the guaranteed rate specified in the contract. This minimum guaranteed interest rate acts as your floor during periods of low interest rates.
Fixed-rate annuities give annuity owners a flexible option for tax-deferred accumulation as well as income options that last a lifetime. Their guarantees depend on the financial strength and claims-paying ability of the issuing insurance company.
Immediate Fixed Annuities
Immediate annuities are typically funded with lump sum payments to insurance companies and payments begin within 30 days. Income payments can also be deferred for up to 12 months. Payment frequency can be monthly, quarterly, semi-annually, or annually for a guaranteed period of time or for life. The duration for these payments will be specified in the contract. With immediate fixed annuities, only the interest portion of each payment will be considered taxable income and the rest is considered a tax-free return of your principal.
Deferred Fixed Annuities
Deferred fixed annuities can be funded with a single lump sum premium payment or regular payments to an insurance company over time to build interest and accumulate funds during the accumulation phase. By postponing taxes while funds accumulate, you can grow it instead of paying taxes on it. This example of tax-deferral is one of the most appealing aspects of annuities. Earnings are not taxed until they are withdrawn, at which time they are considered ordinary income.
Fixed-indexed annuities used to be known as equity indexed annuities. These types of annuities are a type of annuity that credits interest based on the changes in a market index, such as the S&P 500 or Dow Jones Industrial Average. When the index value increases, you are credited interest in the annuity.
However, the interest rate is guaranteed to never be less than zero, even if the market goes down. Thus, you can never lose your principal, and all previously credited earnings are protected from unforeseen downturns in the market.
Variable annuities describe contracts that provide variable returns instead of fixed returns. With these types of annuities, you can decide how much risk you want to take on for your investments. Typically, variable annuity contracts offer professionally managed portfolios called subaccounts, which function much like mutual funds. You can control whether your money goes into stocks, bonds, and money market instruments subaccounts.
In addition to being able to select the subaccounts where you would like to invest your premiums, many variable annuities also offer a fixed interest option. However, there are some cons of variable annuities. Variable annuities do not pay guaranteed fixed returns and their value comes from the performance of the investment subaccounts.
Because these subaccounts fluctuate depending on market conditions, the value of your annuity can decline causing you to lose money. On the other hand, variable annuities give you investment flexibility and tax deferral. The taxes on your interest, dividends, and gains will be deferred until you start making withdrawals.
When you decide, you can cash out your annuity in a lump sum or convert it to an income payment stream called annuitization. If you annuitize, you typically can choose either a fixed or variable payout. The earnings you receive will be subject to income taxes once you make withdrawals or start receiving income. Annuity withdrawals are taxed as ordinary income and they might be subject to surrender charges plus 10% federal income tax penalties if made before the age of 59 ½. Surrender charges can also apply during the contract’s surrender charge period.
Variable annuities also have contract limitations, fees and charges. These can include mortality and expense risk charges, sales and surrender charges, investment management fees, and charges for optional benefits. They are not guaranteed by the FDIC or any other government agency and any contractual guarantees are dependent on the financial strength of the issuing insurance company.
What Is the Best Type of Annuity?
Annuities are an excellent way to generate lifetime income or save for retirement while still managing risk. But these financial products are not simple. Deciding which one is best for you can be a challenge and is dependent on your unique financial situation.
Fixed annuities are safe and will pay you a fixed interest rate, or in the case of an immediate annuity, an income payment on a monthly, quarterly, semi-annual or annual basis. Variable annuities will rise and fall in value depending on how the investment subaccounts perform. Indexed annuities are tied to the performance of an index, such as the S&P 500 and they will credit you with interest based on the performance of that index, while also protecting your principal from any downside loss in value.
Choosing the correct annuity comes down to what you want to use the annuity for, the amount of risk you’re willing to accept, and understanding the specifics of the annuity so you can feel informed and confident with your decision.
Let AnnuityAdvantage Guide You to the Correct Annuity
Because annuities can be complex and are important life decisions that can greatly impact your retirement, it’s wise to consult a professional before making any decisions. For more than 25 years, AnnuityAdvantage has been guiding people who are planning for their retirement to the annuity that fits their needs best. If you think an annuity contract is something you want to explore further, contact us today. We can’t wait to help guide you to the annuity that most closely aligns with your retirement needs.