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What Is A Fixed Index Annuity?

What Is A Fixed Index Annuity?

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Holly Johnson
Updated June 29, 2022
5 Min Read

There are numerous ways to build income streams for retirement, and some of them come with more potential for growth than others. Of course, a certain amount of risk typically opens the door to the potential for more reward. But, what if you could have a healthy mix of both?

That's where fixed index annuities come in. With a fixed index annuity, savers get the benefit of principal protection in a down market without having to give up the opportunity for growth. If you're interested in exploring different ways to save for retirement, read on to learn how this type of annuity works.

Key Takeaways

  • Fixed index annuities offer some potential for upside growth without having to risk your initial investment.
  • A fixed index annuity is a type of insurance contract that is set up with an insurance company or annuity company.
  • Like other types of annuities, fixed index annuities can help provide guaranteed income in retirement.
  • Fixed index annuities provide returns that are based on an underlying index.

What Is A Fixed Index Annuity?

A fixed index annuity is a long-term savings option that offers tax-deferred growth. At its core, this type of annuity is set up to provide principal protection during down market times, but without having to give up the potential for growth. 

Similar to other financial products that have the word "index" included, a fixed index annuity's performance is based on an underlying index such as the S&P 500 or the Nasdaq. This doesn't mean your annuity deposits are invested directly into the index; it just means that your returns will closely follow index returns over time.

How Does A Fixed Index Annuity Work? 

When you invest in a fixed index annuity, you are purchasing an insurance contract that requires a financial contribution on your part. You can pay for your annuity with a lump sum, but you can also make payments toward a fixed index annuity over time. You can even transfer funds from an eligible retirement plan to a fixed index annuity.

From there, your annuity funds have the potential to grow and compound on a tax-deferred basis. However, a fixed index annuity will limit your gains in return for providing principal protection. 

Fixed index annuities have a lot of working parts, which are explained in detail below:

  • Caps: In order to provide protection for your initial investment, fixed index annuities place caps on your growth. While return caps vary, it's possible for fixed index annuities to limit growth on your money to 5% even if the underlying index returns 8% or more.
  • Fees: Fixed index annuities don't actually charge an upfront fee, but they can still be costly. Generally speaking, fees are subtracted from your earnings over time.
  • Loss floor: This type of annuity also limits losses of the principal you invest. If the loss floor is 0%, you wouldn't lose any of your initial investment during a particularly poor year for the underlying index.
  • Participation Rates: A participation rate is a percentage that reflects how much of an index increase you can receive in any given year. Not surprisingly, higher participation rates can lead to greater gains.

The purpose of investing in a fixed index annuity is setting up an income stream you can count on later in life. Once you are ready to begin taking distributions from your annuity, you can receive payments for a fixed period of time or the duration of your life. By and large, the guaranteed income your fixed index annuity provides depends on the details in the contract you set up.

Also note that the tax-deferred status of fixed indexed annuities means you won't pay taxes on growth in your account until you begin taking distributions. Once you begin receiving payments, that's when you'll begin paying ordinary income taxes on those amounts.

Still, it's important to be aware that the tax-deferred status of fixed index annuities can make you vulnerable to additional fees if you need to begin receiving payments before age 59 ½. If you wind up taking money out of your annuity early, you'll have to pay income taxes and a 10% early withdrawal penalty. 

Fixed Index Annuity: Pros And Cons   

Like any other retirement vehicle, fixed index annuities come with their share of pros and cons. Here are some of the main factors to consider before you speak with a financial professional about this type of annuity.

Advantages of Fixed Index Annuities:

  • Benefits for Beneficiaries: In many cases, you can pass on the proceeds of your annuity to beneficiaries designated on your account. You can even purchase optional riders for your fixed index annuity that can increase the amount your beneficiaries receive.
  • Potential for Guaranteed Lifetime Income: Fixed index annuities can provide income for retirement for a specific period of time. You can also purchase a guaranteed lifetime withdrawal benefit rider to guarantee payments for your lifetime.
  • Principal Protection: Fixed index annuities provide protection against losses during down market periods, which is one of the main reasons investors choose this option.
  • Tax-Deferred Growth: Funds invested in a fixed index annuity get the benefit of tax-free growth and compounding over time. You only pay income taxes at your ordinary rate once you begin receiving payments.

Disadvantages of Fixed Index Annuities:

  • Costly Fees: While fees for fixed index annuities are not paid upfront, the fees deducted from your earnings can add up to substantial sums over time. 
  • Lack of Liquidity: A 10% early withdrawal penalty will come into play if you need to access your annuity funds before age 59 ½. 
  • Limited Gains: While fixed index annuities provide protection for your principal, earnings caps and participation rates limit your upside, too.
  • Surrender Charges: Like other types of annuities, fixed index annuities often require surrender charges if you need to cancel your contract before the surrender period ends.

Fixed Indexed Annuity vs. Fixed Annuity

Fixed annuities work similarly to fixed index annuities except for the fact your funds do not provide returns related to an underlying index. Instead, fixed annuities provide a fixed rate of return that is outlined in your contract ahead of time.

This means fixed annuities also provide principal protection. However, the fixed rate of return means you give up some potential for upside based on market conditions.

Fixed Index Annuity vs. Variable Annuity

While a fixed index annuity offers principal protection and a cap on market earnings, a variable annuity lets you feel the full weight of market conditions — good or bad.

This means you can build your account handsomely when the investments in your annuity perform well, but that you can lose principal funds when markets perform poorly.

Is a Fixed Index Annuity Right For You?

A fixed index annuity can provide an alternative to other types of annuities that have too little upside or too much risk. After all, this type of investment lets you benefit from market gains during good years without putting the principal of your investment in harm's way.

However, costly fees and limited earning potential can make a fixed index annuity less attractive than they seem at first. Before you choose this type of annuity or any other, make sure you learn more about how annuities work, as well as their potential advantages and disadvantages. An annuity could be perfect for your retirement planning needs, but you should study up on the details so you know for sure.

FAQ

Can you lose money on a fixed index annuity?

Fixed index annuities come with the benefit of principal protection, so you won't lose money if the market underperforms.

Are fixed index annuities a good investment?

Fixed index annuities have their advantages and disadvantages, yet they are typically considered a "good" investment since they provide principal protection with the potential for growth over time.

What is the difference between a fixed annuity and a fixed indexed annuity?

Fixed index annuities provide returns that are based on the returns of an underlying index like the S&P 500, whereas fixed annuities provide a fixed rate of return.


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