Annuities, explained simply
Learn how fixed and fixed indexed annuities work, what they cost and who they fit.
What an annuity is
An annuity is a contract with an insurance company. You give the company money, either all at once or over time. In return, the company protects your money and can pay you income, now or later.
People often use annuities to add steady income to Social Security and other savings in retirement. Annuities are insurance products. They are not bank deposits.
Fixed and fixed indexed annuities
- Fixed annuity A fixed annuity pays a stated interest rate for a set number of years. You know the rate and the time period up front.
- Fixed indexed annuity (FIA) A fixed indexed annuity, or FIA, credits interest based on how a market index performs, such as the S&P 500. You do not own the index or invest in stocks. When the index rises, you can earn interest, up to a limit. When the index falls, your account does not lose value because of the drop.
What to know about a fixed indexed annuity
- Protection from market loss If the index falls, your account earns zero interest for that period and does not lose value because of the drop. Taking out too much money early, surrender charges and rider fees can still lower your account value.
- Growth potential tied to an index The company limits how much interest you can earn. It does this with a cap (a top rate), a participation rate (a share of the gain) or a spread (an amount subtracted from the gain). The company can often change these limits each year. In a strong market year, your interest will likely be lower than the market's gain.
- Tax-deferred growth You pay no tax on interest until you take money out. Earnings you withdraw are taxed as ordinary income. If you take money out before age 59 and a half, you may also owe an extra 10 percent federal tax.
- Income options Many contracts let you turn your balance into income you cannot outlive. You can do this with a rider, which is an optional add-on that usually has a fee, or with a payout option. The amount depends on your age, your balance and the contract terms.
- Legacy options If you pass away, your beneficiaries usually receive the account value. Some contracts offer other choices.
About surrender periods
Most annuities have a surrender period. This is a set number of years, often 5 to 10 and sometimes longer. If you take out more than the allowed amount during that time, you pay a surrender charge. The charge is highest in the first year and gets smaller each year.
Many contracts let you withdraw a portion each year, often up to 10 percent, with no surrender charge. Some contracts waive the charge in certain cases, such as a serious illness. Terms vary by company.
A surrender period is a key trade-off with an annuity. Plan to leave the money in place for the full period, and keep cash elsewhere for emergencies.
Annuity, 401(k) or IRA? Many people use more than one.
These accounts do different jobs. Here is a fair look at both.
| Fixed indexed annuity | 401(k) or IRA | |
|---|---|---|
| Main goal | Protect savings and create income | Grow savings over many years |
| Market loss | Your account does not lose value because the index falls | Your balance rises and falls with your investments, and you can lose money |
| Growth potential | Limited by caps, participation rates or spreads | Higher potential, with no cap and more risk |
| Retirement income | Can offer income for life through a rider or payout option | You choose your own withdrawals, with no built-in guarantee that the money lasts for life |
| Taxes | Interest grows tax-deferred. Withdrawn earnings are taxed as ordinary income | Traditional accounts grow tax-deferred. Roth accounts can offer tax-free withdrawals if the rules are met |
| Adding money | Usually no yearly limit when bought with after-tax money | Yearly limits set by law. Some employers add a match to a 401(k) |
| Access to your money | Surrender charges apply during the surrender period | You can usually withdraw at any time, subject to plan rules, taxes and a possible 10 percent penalty before age 59 and a half |
| Costs | Rider fees and surrender charges may apply | Fund expenses and account fees apply |
| What backs it | The claims-paying ability of the insurance company | The value of your investments |
An annuity can also be held inside an IRA. A tax professional can explain how that works for you.
Who annuities may fit, and who they may not
An annuity may fit if:
- You are near or in retirement and want to protect part of your savings from market drops
- You want a base of steady income on top of Social Security or a pension
- You have emergency savings you can reach without touching the annuity
- You are comfortable leaving the money in place for the full surrender period
An annuity may not fit if:
- You may need the money within the next several years
- You have no emergency savings
- You want the highest long-term growth and can handle market ups and downs
- You are still building savings and a 401(k) with an employer match could do more for you
- The terms still feel unclear. Ask us to explain them before you decide.
Questions to ask before you buy any annuity
- How long is the surrender period, and what is the charge each year?
- How much can I withdraw each year with no charge?
- What are the cap, participation rate or spread, and can the company change them?
- What do riders cost, and what do they provide?
- How does an independent rating agency rate the company's financial strength?
Why work with Bridgemont Life
We compare annuities from many carriers and explain the trade-offs in plain language. We also tell you when an annuity may not be the right choice for you.
Disclosure: Annuities are insurance products. They are not bank deposits and are not insured by the FDIC. Guarantees, including protection from market loss and lifetime income, depend on the claims-paying ability of the company that issues the annuity. Surrender charges and taxes may apply to withdrawals. The information on this page is general education. It is not investment, tax or legal advice. Talk with a qualified tax or financial professional about your situation. Features, rates and availability vary by company and state.