How a Fixed Index Annuity Can Fill the Retirement Income Gap

Over the past decade or so, the fixed index annuity has become a key component of retirement income planning. Because people (on average) are living longer lives today, one of the biggest fears on the minds of retirees – as well as those who are preparing for retirement – is running out of income while it is still needed.

In addition, even with Social Security and other dependable sources of future income, there is a still a chance that retirees may have a “gap” between incoming cash flow and outgoing living expenses.

But a fixed index annuity can provide you with a solution.

What is a Fixed Index Annuity?

While fixed annuities can provide you with a number of benefits, both before and after you retire, these financial vehicles are also one of the easiest to understand. A fixed index annuity represents a contract between you and the insurance company that offers it.

With this type of annuity, you can either make one single lump sum contribution, or alternatively, you can make numerous contributions over time. Fixed annuities provide a set interest rate, so you can count on at least some amount of growth over time.

The money inside of a fixed index annuity is allowed to grow tax-deferred. This means that no tax is due on the gain until the time it is withdrawn. This tax-deferral can allow your funds to grow and compound exponentially as they earn a return on your contributions, as well as on the interest, and on the money that would otherwise have been paid out in taxes each year.

Due to their simplicity, fixed annuities offer peace of mind in knowing that your principal will remain safe in any type of market condition. You can also count on a set, reliable stream of income for as long as you need it – which includes a lifetime income feature that continues to payout for the remainder of your lifetime (regardless of how long that may be).

How Do Fixed Annuities Work?

Fixed index annuities offer their holders a set amount of interest that is credited on an annual basis. This rate is declared by the offering insurance company, and unlike a variable annuity or an indexed annuity, the return on a fixed index annuity is not tied to the performance of the stock market or an underlying market index like the S&P 500.

So, a fixed index annuity can provide predictability in knowing that no losses will occur, even in the event of a market downturn. In return for this safety, though, the return on a fixed annuity during its “accumulation” phase is generally lower than what you could receive with an equity-linked financial vehicle.

A fixed index annuity can also provide an ongoing income stream. This occurs during the “annuitization” phase. Because you can count on a set income amount over time with fixed annuities, it can be easier to plan ahead, knowing how much incoming cash flow you can count on in retirement.

Types of Fixed Index Annuities

There are two primary types of fixed annuities. These include:
  • Term certain annuities, and
  • Life annuities

A term certain annuity will pay income for a set period of time. So, there is a chance that the payout will stop while the annuitant is still alive. This payout alternative can be a viable option, though, for those who only need income for a certain number of years.

As an example, you may wish to retire before your Social Security income is accessible. In this case, the income from a term certain annuity can help you to fill in that income “gap” until your Social Security retirement benefits begin.

With a life annuity, the income recipient (or annuitant) will receive a predetermined amount of payout – which is typically paid out on a monthly basis – until he or she passes away. This can be a good option for those who don’t want to worry about running out of income in the future. There are actually several different forms that the income from a life annuity can take.

Fixed Index Annuity Payout Options

One reason that people purchase fixed annuities is for the ongoing and reliable income stream that they can provide. Most fixed annuities offer several different income payout options, such as:
  • Period Certain – With the period certain annuity payout option, you will receive income for a set amount of time, such as 10 or 20 years. Once this time period has elapsed, no further payments will be received from the annuity. If you pass away before the number of years has elapsed, the remaining fixed index annuity payments can be paid to a named beneficiary for the remainder of the period.
  • Lifetime Income – If you choose the lifetime income annuity payout option, you will continue to receive a payment for the rest of your life – regardless of how long that is. The lifetime income option oftentimes offers the largest amount of total income received – especially if you live a long life.
  • Life with Period Certain – The life with period certain option “combines” the period certain with the lifetime payment alternatives. So, you will receive payments for the rest of your lifetime. However, if you should pass away within a certain period of time, your beneficiary will continue to receive the annuity income for the remainder of the set time period.
  • Joint and Survivor – With the joint and survivor option, the annuity will pay an income stream for the remainder of two peoples’ lives. This is oftentimes used with married couples or partners who want to ensure that both individuals can rely on an income stream throughout their lifetimes.
  • Lump Sum – You may also opt to withdraw a lump sum – or even the entire amount of the annuity’s account value – at a time in the future. If you go this route, however, it is important to understand that you can owe taxes on all of the gain, which will have to be paid for the year of the withdrawal.

Fixed Annuity Riders and Optional Features

Depending on the type of fixed index annuity you have, you may be able to further enhance the income that is received. For example, indexed annuities with a guaranteed income rider can provide you (as well as a joint income recipient) with a guaranteed percentage of your original investment as an income payment – even if the annuity’s account does not have any more money in it.

In this case, it is important to understand that the growth rate does not apply to the annuity’s contract value, but rather only to the income that is produced by the annuity. So, you are not tied to a lump sum that you can withdraw all at one time. In addition, the growth rate on the annuity income rider only applies when you start to take an income stream from the annuity.

It is also important to keep in mind that even though fixed annuities all share some of the same characteristics, they are not all exactly alike. For instance, fixed index annuity rates may differ from one insurance company to another.

In addition, some fixed annuities may offer additional features and/or optional benefit riders that can be purchased for an added premium charge. Also, not all fixed annuities have the same fees or surrender period, so it is essential that you know exactly what you are getting before you make a long-term commitment.

Working with an annuity specialist can help you to sort out the differences between fixed annuities, which can be beneficial in narrowing down which – if any – may be right for you and your specific objectives.

How a Fixed Index Annuity Death Benefit Works

If an annuity income recipient dies before his or her guaranteed income stream has been paid out, then the remainder may be paid to a named beneficiary in the form of a death benefit. A fixed index annuity death benefit can help to ensure that your principal will not be lost – even in the event of the unexpected.

The funds may be paid to the beneficiary as a lump sum, or as a series of payments. Unlike the non-income-taxable death benefit that is paid from a life insurance policy, though, an annuity’s death benefit will typically be taxed as ordinary income on the portion that is considered gain. (However, withdrawals of after-tax contributions from the annuity are not subject to taxation).

Fixed Annuity vs Variable Annuity

Annuities can come in a variety of different formats. These include fixed and variable annuities. Although these two types of annuities both allow for tax-deferred growth and an ongoing income payment, there are several differences – primarily as it relates to how the annuity’s return is calculated.

For example, fixed index annuity rates are set by the insurance carrier at the outset of the contract. These rates can provide you with both safety and predictability in any type of market or economic environment.

So, because of fixed annuities’ guaranteed features, you know that you won’t lose principal. However, the “tradeoff” for this is typically a low return that may not be able to meet, much less beat, future inflation.

The performance of variable annuities is tied to various investments. While a variable annuity can provide you with the opportunity to increase your return (in some cases, substantially), there is also much more risk – and you could end up losing money in this type of annuity.

Before you purchase any annuity, it is best to discuss your financial goals, as well as your risk tolerance and your retirement time frame with an annuity expert. That way, you can be more assured that you are choosing the right annuity option.

Taxation of Fixed Annuities

Even though fixed annuities allow for tax-deferred growth, it doesn’t mean that you can avoid Uncle Sam altogether. How your annuity income is taxed, though, is dependent on whether you have a qualified or non-qualified annuity.

If you own a qualified fixed index annuity (i.e. an annuity that is purchased with pre-tax contributions from a traditional IRA or employer-sponsored retirement plan), it is likely that none of the money in the annuity has been taxed – including your contributions. In this case, 100% of your income payout and/or withdrawals would be subject to income tax.

Alternatively, if you have a non-qualified annuity – one that you’ve purchased using after-tax dollars for your contributions – you will owe tax on a portion of each income payment. Insurance companies use a concept known as the “exclusion ratio” to determine what percentage of the annuity’s payment is taxable.

If you make withdrawals from an annuity before you have turned age 59 ½, you can also be subject to an additional 10% IRS “early withdrawal” penalty. So, it is important to be mindful of how much income you will actually net when making annuity withdrawals.

The Fixed Index Annuity Formula

For many people, relying on an unknown amount of income in retirement can lead to future cash flow problems. That’s why it is important to understand the present value of an annuity so that you can determine its future value.

As an example, if you know how much you need to invest over time – and for a certain amount of time – then you will have a better idea of how much income you will be able to count on in the future in terms of cash flow.

Although there are a number of websites that can help you with calculating the fixed index annuity formula, it is oftentimes best to talk directly with an annuity expert who can answer any of the questions you have along the way. They may also be able to show you different annuity options, based on your particular goals.

The Pros and Cons of a Fixed Index Annuity

Just like with any other type of financial vehicle, fixed annuities can have both pros and cons. These will oftentimes depend on your objectives and on what you actually want the annuity to do for you.

One of the benefits of a fixed index annuity is the safety it can provide with your principal. In today’s volatile stock market, losses can occur quickly – and there’s no guarantee that the account value of an equity-rich portfolio will ever come back. So, if you’re looking for safety, tax-deferral, guaranteed growth, and predictability, a fixed annuity could be a good option for you.

On the other hand, although fixed annuities can provide many benefits, there are also some items to consider before you commit to purchasing one. For instance, one of the key disadvantages of a fixed annuity is its low return – particularly in comparison to what you might be able to earn with a variable, or even indexed annuities.

There are some other fixed index annuity risks, as well. For example, while you won’t technically “lose” money with a fixed annuity, the return won’t likely keep pace with inflation. Therefore, your future purchasing power could be diminished, forcing you to reduce your current lifestyle in retirement.

Should I Buy a Fixed Index Annuity?

Deciding whether or not to purchase a fixed annuity can be difficult. These financial vehicles can provide you with some enticing benefits, such as guaranteed growth and principal protection in any market. But they can also leave you behind in terms of both short and long-term inflation protection and purchasing power.

Prior to making any type of commitment to purchase an annuity, then, it is recommended that you discuss your objectives with an experienced annuity specialist – and ideally one who has access to annuities from a long list of top-rated insurance carriers.

Are you ready to find the best fixed index annuity for your retirement needs?

Feel free to reach out to us directly by phone at (918) 938-7734, or via our secure online contact form here to schedule a time to chat. We look forward to hearing from you.