How a Fixed Annuity Works After Retirement

If you have a job, you may be able to contribute to a 401(k), a retirement account offered through your employer. Other retirement plan options include individual retirement accounts (IRAs), Roth IRAs, health savings accounts (HSAs) that allow you to save money for medical expenses during retirement, or a fixed annuity.

These annuities come in many shapes and sizes and are generally offered through insurance companies and investment firms. Some investors use them to supplement their existing retirement resources. But is a fixed annuity the right choice for you? Find out what you should know about payouts, the tax implications, and other considerations.

What Is a Fixed Annuity?

A fixed annuity is a contract between an investor and an insurance company. The investor, who is also called an annuitant, contributes money to the annuity in exchange for a guaranteed interest rate during the annuity’s accumulation phase and a predictable income stream during its payout phase.

Investors can purchase fixed annuities during the accumulation phase using a lump-sum of money or by making smaller payments over time. Income is paid out by the issuer based on the owner's age, account balance, interest accumulated based on the agreed-upon rate, and other key factors.

Fixed annuities aren't the only ones available to investors. Variable annuities, by contrast, are tied to mutual funds and other market-based securities chosen by the buyer, and they fluctuate in value accordingly.

Since variable annuities don't provide a guaranteed payout, many risk-averse investors choose fixed annuities for retirement instead. Their slower growth is the price investors pay for the security of a set interest rate.

Immediate vs. Deferred Fixed Annuities

The income from a fixed annuity can be either immediate or deferred. With an immediate annuity, the buyer makes a single, lump-sum payment to the insurance company. Payouts begin almost immediately, and they usually continue for the rest of that person’s life.

Immediate annuities are often attractive to retirees or soon-to-be retirees who worry about potentially outliving their resources. An immediate annuity is also an option for someone with a large, one-time windfall, such as an inheritance or profits from selling a business, and wants to convert it into an income stream.

A deferred annuity, on the other hand, begins its payouts at some point in the future chosen by the buyer. With a deferred annuity, the annuitant either contributes a lump-sum, makes a series of contributions over time, or does some combination of the two. These annuities are aimed at people who are still some years away from retirement and don’t need the income right away.

Fixed Annuity Payouts

When an investor wants to receive income from their annuity, they notify the insurance company. The insurer’s actuaries calculate the amount of the periodic payment. This calculation includes a number of factors, including the dollar value of the account, the annuitant’s age and life expectancy, the likely future returns on the account’s assets, and whether the annuity is intended to provide income to a spouse after the annuitant dies.

Generally, annuitants receive larger payouts the longer they wait. Most annuitants choose to receive monthly payments for the rest of their lives and their spouse’s life, through a joint and survivor annuity. Once both are deceased, the insurer typically stops the payouts altogether.

If an annuitant lives for a long time, the value they get from their annuity could be more than they paid into it. If they die too soon, however, they may collect less than they paid in. Nonetheless, both scenarios accomplish the main selling point of an annuity: Income for the rest of life, however long or short it turns out to be.

Annuities may also include additional provisions, such as a guaranteed number of payout years. With this option, if the annuitant and their spouse die before the guaranteed period is over, the insurer will pay the remaining funds to the couple’s heirs. Generally speaking, the more provisions included in an annuity contract, the smaller the monthly payouts will be.

How Fixed Annuities Are Taxed

Most annuities offer tax advantages. Contributions are tax-deductible if the annuity is a qualified annuity, and investment earnings grow tax0-free until the annuitant begins to draw income from them. As with IRAs and other retirement accounts, those tax-deferred earnings can grow and compound more quickly over time than if the money were in a regular, taxable account.

Once the payouts start, the annuitant will have to pay taxes on them at their ordinary income tax rates—not capital gains rates, which are generally lower. That’s also true of most kinds of retirement accounts. However, the annuitant may be in a lower tax bracket by then, as many people are in retirement.

Special Considerations

Annuities, whether fixed or variable, have their downsides. Their costs tend to be high compared to those of mutual funds and certificates of deposit (CDs). Annuities are often sold through agents, and the cost of their commission is passed on to the buyer. Annuities also come with sizable annual expenses, including a mortality and expense risk charge of about 1.25%. Any special riders will usually increase the costs.

With many deferred annuities, the annuitant may have to pay a surrender fee if they withdraw funds during the early years of the contract—typically, six to eight years or even longer. Early distributions may also be subject to tax penalties before the annuitant reaches age 59½. However, most annuities have provisions that allow penalty-free withdrawal of 10% of the account for emergency purposes.

Anyone who needs money from an annuity before regular payouts begin should read their contract carefully and consider consulting a knowledgeable financial advisor.

Annuities and the COVID-19 Pandemic

Virtually everyone has been impacted in some way by the global COVID-19 pandemic, including retirees and non-retirees. The U.S. federal and state governments have provided relief to taxpayers through stimulus checks and extended unemployment insurance benefits. But there are also provisions in place for those who are looking to their retirement accounts for relief.

The passage of the $2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act included exemptions for those who needed to make withdrawals of up to $100,000 from their retirement resources before the end of the 2020 tax year without facing early withdrawal penalties. This provision was not carried over into 2021, which means anyone who makes a withdrawal from their retirement accounts in 2021 is responsible for the 10% penalty.

Some states have also extended a grace period to consumers who demonstrate a hardship due to the pandemic to make payments for an annuity contract. For instance, insurers must provide consumers with an opportunity to make up late premium payments for their annuities in New York as per an order issued by Gov. Andrew Cuomo.

The Bottom Line

Annuities are just one of the many options available for your retirement portfolio. You can purchase a contract through an insurance or investment firm. Fixed annuities, more specifically, can provide you with some security, as they offer investors a guaranteed rate of interest. Money is accumulated either in a lump sum or regular monthly payments. Payouts vary based on your age, the amount in your account, and your life expectancy.

But remember, there are certain tax implications that come with these vehicles—you must pay taxes at regular income tax rates. If you're on the fence about jumping into an annuity contract, consider speaking with a retirement specialist to see if it's the right fit for you.