Posted by The TaxAdvocate Group, LLC

What is a Fixed Index Annuity?

What is a Fixed Index Annuity?

Calculating how much you will need for your retirement and understanding the different products and their benefits are important to your financial well-being. Fixed index annuities are an option that many Americans are considering including in their retirement planning toolbox. This article answers frequently asked questions to help you better understand how fixed index annuities work.


What is a fixed index annuity?

Like most other annuities, a fixed index annuity is a financial product offered by an insurer that will guarantee a level of income for life. What makes it unique is that it shares some common features with fixed deferred interest rate annuities in addition to being a tax benefit product.

However, there is also a component of the index annuity. Therefore, the annual rise is compared to a stock index such as the Nasdaq, NYSE, or S&P 500 rather than an interest rate. Since the growth of an index annuity is subject to thresholds and minimum commissions, it will never exceed or fall below specified performance levels. This is the case even if the capital ratios fluctuate.

In short, with a fixed index annuity, the insurer assumes all the risks associated with the stock market. Even in the event of a sharp drop, you will not lose your capital. And there is also the possibility that your potential income will be capped at a rate between 3% and 9%.

As if that weren't enough, it's not uncommon for fixed-rate annuities to offer premium bonuses. But often, this comes at the expense of lower potential gains.


How do fixed index annuities work?

A fixed annuity is a long-term insurance contract. It offers two different ways to earn interest. They are also called crediting strategies.

The "fixed" part of the strategy is the one that presents the least risk and the greatest benefit. For this strategy, the insurer offers retirees a fixed interest rate for a specified number of years. If you have already purchased a Certificate of Deposit (CD), you should spot the similarities.

Usually, the initial charge is one year. After this period, the rate is reset. However, it will never fall below the minimum rate guaranteed by the insurer.

The other crediting strategy is the "indexed" portion of the annuity. This offers greater benefits as the money in this part of the annuity account will earn interest based on the performance of an index such as the S&P 500, Nasdaq, Russell 2000, or Hang Seng. However, these fees are often limited. Therefore, you need to know them to make sure that they are worth investing in this type of annuity.

An example of this would be the fact that technically your money is not going into the index fund. In addition, insurers generally offer a 0% floor.

What does this mean exactly? Well, your money will not increase and will stay exactly the same.

And, due to participation limits and commissions, your returns may not be as high as you would like. It generally works as follows;

  • Rate cap: Suppose you have a 6% price limit on your contract. This will be the maximum return you will receive. Even if the index returns 9%, it will still be tied to the 6% rate limit.

  • Participation rate: If the contract includes a participation rate, you will get a certain percentage of the increase in your index experiences. This means that if your contract has a 50% participation rate and your index grows 8%, expect a return of 4%.

Once you've created and opened your account, you can decide how much to allocate to each strategy. Since there are often more index strategy options, you have the opportunity to allocate more money. Anything that hasn't contributed to an index will increase at your contract's current fixed rate.

And remember that annuities of any type are produced by saving for retirement. Therefore, there are some strict disposal rules that you need to know. For the most part, you will face high withdrawal fees if you withdraw money from your account before the contract terms say so. Additionally, the IRS will charge a 10% early withdrawal penalty if you withdraw funds from your account before age 59½.


How to invest in a fixed index annuity

Do you intend to set up a fixed annuity of your own? Well, the first step is to buy a contract. In fact, you have several options for doing so. You can make an initial deposit, make a series of payments over a period of time, or even transfer funds from another pension plan. The next step is to tell the company that purchased the annuity how you want your money invested.

While it can be overwhelming if you're new to annuities, you can do your best to index your money, or you can be a little more careful about allocating it to different indexes. The return you will receive is based on the performance of the market indices you have chosen.


 Benefits of Fixed Index Annuities

Are you considering a fixed index annuity? If you're not 100% on board yet, here are five reasons why you should consider buying one.

  • Flexibility: In addition to deciding how to invest your money and how to get paid, you can add on riders as death benefit options for your beneficiaries.

  • Guaranteed retirement income: If you're worried about running out of money or outliving your savings, an annuity can solve the problem if you choose to receive recurring payments for life.

  • Increase in deferred taxes: You will not be billed for your fixed index annuity until you start to withdraw. As such, it can help you grow your annuity faster.

  • Protection against inflation: A fixed index annuity will have a higher return than a fixed annuity or certificate of deposit (CD). Plus, these interest rates are locked in and can help your savings outperform inflation.

  • Protection against losses: Perhaps the most attractive feature of a fixed index annuity is that you won't lose sleep over losses during a market recession. In other words, your annuity will not lose value.


Disadvantages of fixed indexed annuities

With all the advantages that a fixed index annuity offers, there are disadvantages to it.

  • High taxes: With the exception of paying a substantial amount of your annual income to your annuity company due to high annuity fees and income limit.

  • Low growth potential: Due to participation rates or rate caps, you can lose exceptionally good performance indexes.

  • Surrender Charges: You will also owe the annuity company large fees if you terminate the contract before the termination period.

  • Uncertainty: While not as prevalent as the unpredictability of a variable annuity, there is some uncertainty about your payout amount because you can't predict what the market will do.


Fixed Index Annuities vs. other types of annuities

Suppose you can learn anything from this guide. In that case, you know what type of annuity contract is right for you, and the only way to determine that is to compare a fixed index annuity to a fixed or variable annuity.


• Variable income vs. fixed index annuity: Both types of annuities place your money in money market funds. However, a variable annuity will give you the best potential return. Compensation is the risk involved. A fixed index annuity is less risky because you will get some exposure to the market without incurring big losses. After all, you will get a predetermined interest rate.


• Fixed income vs. fixed index annuity: You will receive a predetermined interest rate with both types. However, with a fixed income, you are also playing in the market. In return, you will get potentially higher income limits and participation rates. On the other hand, it is not as predictable as a fixed annuity.

In general, fixed indexed annuities are the best in both worlds. You can enjoy the advantages of a fixed and variable annuity without any inconvenience. In addition, a fixed index annuity is extremely flexible and is worth looking for if you want a less risky and semi-predictable medium to long-term investment.


FOR MORE INFORMATION ON HOW THE TAXADVOCATE GROUP, LLC. CAN BEST HELP YOU WITH YOUR TAX FILING NEEDS, PLEASE CLICK THE BLUE TAB ON THIS PAGE.


THANKS FOR VISITING.

The TaxAdvocate Group, LLC
Contact Member