Annuities have special features and tax benefits to help you save for retirement. However, where there are tax benefits, there are usually strings attached. Annuities are no exception, and as such, may not be the right option for everyone.
An independent insurance agent can help you determine if a fixed index annuity is right for you. They can help shop and compare equity-indexed annuities and other options for you to find the best deal. But first, here's a guide to indexed annuities and how they work.
What Is an Indexed Annuity?
Annuities are policies issued by insurance companies that pay a regular income for life or for a set period of time. You can buy an indexed or fixed annuity policy by making a single payment or a series of payments.
Indexed annuity definition
Indexed annuities are often used to create a regular stream of retirement income. An indexed annuity is a contract that offers higher yields than fixed annuities. An indexed annuity's growth potential is higher because the contract pays interest based on a market index, such as the S&P 500.
Indexed annuities are beneficial because they ensure that the principal stays protected. You'll get a minimum return from an indexed annuity even if the market has taken a downturn. Indexed annuities offer a wide choice of benchmark indexes and performance measures:
- Guaranteed lifetime income: You can select from six or more income options, all of which are guaranteed. Additional lifetime income riders are available at a cost.
- Tax-deferred growth: Unlike CDs and savings accounts, the growth in a fixed index annuity is not taxed until you begin to take income or other distributions.
- Creditor protection: Most states offer annuities some form of creditor protection. In some cases, these are unlimited protections.
Ask an independent insurance agent to help you compare indexed annuities and their benefits with other types of annuities to make an informed choice. Your agent can also help you compare average returns on popular indexed annuities.
How Do Indexed Annuities Work?
Fixed index annuities offer growth potential without stock market risk. Index accounts credit some of the gains of a market index, such as the S&P 500, and none of the losses. For indexed annuity returns, the portion of gains credited is measured by:
- Participation rate: This is a percentage of the gain.
- Cap Rate: This refers to gains up to a stated percentage.
The gains are also measured for a term, usually one to five years. Finally, the gains are measured by one of the following:
- Point to point: This is the market index value at the end of the term, measured against the market value at the beginning of the term.
- Monthly average: This is the market index value in the first month measured against the average monthly index value during the term.
- Trigger point: This is a fixed rate of interest that's credited if the index rises above a stated level by the end of the term.
An independent insurance agent can help you weigh the pros and cons of fixed-indexed annuities to determine if they are the best investment option for you.
Indexed Annuity Rates
The participation rate of an indexed annuity is a percentage of the gain. Participation rates can be as high as 100%, in which case the owner of the annuity would receive all of the gain credited to their account. Participation rates can also be as low as 25%, but most indexed annuities come with participation rates of between 80%-90%.
How Much Does a Fixed Index Annuity Cost?
The cost of a fixed income annuity depends on the following:
- Front-end sales loads: The front-end sales load is deducted from your purchase payment. Most products on the market today don’t have a front-end sales load.
- Surrender penalty: Most fixed index annuities charge a fee if you cash in your contract or withdraw more than 10% of the cash value. Surrender penalties decline to zero over a period of years, usually not more than 10.
- Market value adjustment: The market value adjustment will be a cost or a bonus depending on interest rates at the time of surrender. Market value adjustments only apply during the surrender period.
- Rider fees: Optional riders, like living benefits, have additional fees.
Your independent insurance agent can help you find a fixed index annuity at a great rate.
How Do I Get Income from a Fixed Index Annuity?
The income from a fixed index annuity is determined by the account value and the option that you select. The chart below outlines the options.
Guaranteed Income Options
| During Lifetime | At Death | Advantages | Disadvantages | |
|---|---|---|---|---|
| Life | Pays income for the annuitant’s life | None | Highest income | No refund of unused principal |
| Life and 10 Years Certain | Pays income for life, not less than 10 years | Balance if death occurs before the end of 10 years | Protection for beneficiaries | Lower income |
| Life and 20 Years Certain | Pays income for life, not less than 20 years | Balance if death occurs before the end of 20 years | Protection for beneficiaries | Lower income |
| Life with Cash Refund | Pays income for life, payments are at least a specified refund amount | Balance of refund amount | Protection for beneficiaries | Lower income |
| Period Certain | Pays income for a specified number of years | Balance of payments | Useful for certain planning purposes | Outliving income |
| Joint & Survivor 100% | Pays income for the longer of the two lives | No further payments on the second death | Surviving spouse continues to receive income for life | Lower income |
| Guaranteed Lifetime Withdrawal Benefit Single Life | Pays income for an annuitant’s life | Balance of account | Access to account values, death benefit | Income taxed as withdrawals |
| Guaranteed Lifetime Withdrawal Joint Life | Pays income for the lifetime of the annuitant and the second life | Balance of account at second death | Access to the account, death benefit | Income taxed as withdrawals |
How Is a Fixed Index Annuity Taxed?
Tax treatment for traditional qualified annuities, Roth-qualified annuities, and non-qualified annuities is different. The chart below summarizes the tax treatment of retirement annuities.
| Non-Qualified | Qualified | Qualified/Roth | |
|---|---|---|---|
| Contributions | After-tax, unlimited | Pre-tax, limits for IRAs and qualified plans apply | After-tax, limits for IRAs and qualified plans apply |
| Growth | Tax-deferred | Tax-deferred | Tax-deferred |
| Surrender | Gain is taxed at ordinary rates. | All proceeds taxable | Tax-free |
| Annuity Income | Partially taxable at ordinary rates | 100% taxable at ordinary rates | Tax-free |
| Withdrawals | Withdrawals are gain first, gain is taxed at ordinary rates. | 100% taxable at ordinary rates | Tax-free |
| Loans | Loans are considered withdrawals; gain first is taxed at ordinary rates | IRA loans are not permitted; pension plans may have exceptions for home purchase and loans repaid in five years | IRA loans are not permitted; pension plans may have exceptions for home purchase and loans repaid in five years |
| Death Benefits | Gain is taxed at ordinary rates; proceeds will be taxed as "gain first" | Rules for inherited traditional IRAs and qualified plans apply | Rules for inherited Roth IRAs and plans apply |
| Sales | Proceeds in excess of the basis are taxed at ordinary rates | N/A | N/A |
| Penalties | 10% for withdrawals before age 59-1/2 | 10% for withdrawals before age 59-1/2 | 10% for withdrawals before age 59-1/2, penalty for withdrawals prior to the end of the fifth year |
What Happens to the Money in a Fixed Index Annuity When You Pass Away?
If you pass during the deferral period, your beneficiary will receive the account value. If you pass during the distribution period, the income option that you selected will determine what the beneficiary will receive. Optional riders may enhance the death benefit.
Is a Fixed Index Annuity Right for Me?
You have a lot of options when it comes to annuities and investments, such as an indexed annuity vs. a variable annuity, an indexed annuity vs. a fixed annuity, and an indexed annuity vs. mutual funds. Fortunately, there are some simple questions you can ask yourself to determine whether a fixed index annuity is the right choice:
- Tax-deferred growth: This is a major benefit of fixed annuities. Is tax control important to you? Can you benefit from tax-deferred growth?
- Growth potential without market risk: Are you a conservative investor? Are you looking for higher potential returns than CDs and fixed-rate annuities? Are you willing to accept 0% growth in “down years”?
- Surrender and tax penalties: Do you have adequate resources for emergencies and other short-term needs during the surrender period or after a tax penalty?
- Guaranteed income for life: Do you want a fixed guaranteed income for life instead of income that may benefit from market returns?
Your independent insurance agent also knows the right questions to ask to determine whether a fixed index annuity is right for you.
What Should I Look for in a Fixed Index Annuity?
The first concern for any type of annuity is the financial condition of the insurance company. The primary rating services that cover insurance companies are AM Best, Moody’s, S&P Global (formerly known as Standard & Poor's), and Fitch. Each has differences in its methodologies and rating designations.
The rating each service assigns reflects its opinion about the insurance company's ability to pay claims. Look for high-quality ratings from at least two of the four.
| Highest Ability To Meet Obligations | Medium Ability To Meet Obligations | Lowest Ability To Meet Obligations | |
|---|---|---|---|
| AM Best | A++ to A- | B++ to B- | C++ to C- |
| Moody's | Aaa to Aa | A to Baa | Ba to Caa |
| S&P | AAA to A | BBB to B | CCC to C |
| Fitch | AAA to AA- | A+ to BBB- | BB+ to CC |
Rates on fixed index annuities change frequently. Make sure you have a rate comparison from several companies. The surrender period should never be longer than 10 years. Additionally, consider whether the annuity is a market value adjustment (MVA) policy. The MVA can have a positive or negative effect if you withdraw money or surrender the policy early.
Here's How an Independent Insurance Agent Can Help
Fixed index annuities can be an important part of your retirement plan. While they have many features and benefits, they are not for everyone.
An independent insurance agent can help you weigh your options to find the best indexed annuities of 2025. If a fixed annuity isn't right for you, your agent will help you find the option that provides the best fit.
