How a Fixed Annuity Works and What You Get Paid

What a fixed annuity is

A fixed annuity is a contract you buy from an insurance company that pays you a set amount of money at regular intervals — usually monthly — for a period you choose in advance. The insurance company guarantees both the payment amount and the schedule, which means your income does not change if markets rise or fall. You give the company a lump sum upfront (called the premium), and in return it promises to send you those payments for as long as you live, for a set number of years, or until the money runs out, depending on which option you pick when you buy the contract.

The insurance company invests your premium in bonds and other stable investments, not in stocks. Because the company bears the investment risk — not you — it can afford to may provide your payment amount. This is the core difference between a fixed annuity and a variable annuity, where your payment amount changes based on how an investment portfolio performs.

Key Takeaways

• A fixed annuity pays you a may provide amount each month, and that amount never changes regardless of market conditions or how long you live.
• You pay the insurance company a lump sum upfront, and they invest it conservatively while guaranteeing your income stream.
• The payment amount is set when you buy the contract and depends on your age, the size of your premium, and how long you want payments to last.
• Fixed annuities are taxed differently depending on whether you buy them with pre-tax retirement account money or after-tax money, and withdrawals before age 59½ may carry a 10 percent penalty.
• You cannot change the payment amount once the contract starts, so you lock in a rate of return that may not keep pace with inflation.

How the payment amount is determined

When you buy a fixed annuity, the insurance company calculates your monthly payment using three main factors: your age at the time of purchase, the size of your premium, and the payout period you select. Younger buyers receive smaller monthly payments because the company expects to pay them for more years. Older buyers receive larger monthly payments because the payout period is shorter. A $100,000 premium will generate different monthly income depending on whether you are 55 or 75.

The insurance company also looks at current interest rates. When interest rates are higher, the company can pay you more each month because it earns more on its investments. When rates are lower, your monthly payment is smaller. This is why two people buying identical annuities at different times may receive different payment amounts for the same premium.

The payout period you choose also changes the calculation. If you select a 10-year certain period, your monthly payment will be higher than if you select a 20-year period, because the company pays out the same total amount over fewer months. If you select lifetime payments, the calculation depends on life expectancy tables the company uses.

Fixed annuity payout options

When you purchase a fixed annuity, you choose how long you want to receive payments. The most common options are:

• Life annuity (or straight life): Payments continue for as long as you live, then stop. Your heirs receive nothing. This option produces the highest monthly payment because the company does not know how long it will pay you.
• Life with period certain: Payments continue for your lifetime, but if you die before a set period (often 10 or 20 years), your heirs receive the remaining payments. This option pays less per month than straight life because the company has a may provide minimum payout.
• Period certain only: Payments last for a fixed number of years (5, 10, 15, or 20 years) regardless of whether you live or die. If you die before the period ends, your heirs receive the remaining payments. This option pays less per month than life annuity.
• Joint and survivor: Payments continue for your lifetime and then for your spouse's lifetime at a reduced amount (often 50 or 75 percent of your payment). This option pays the least per month because the company expects to make payments for two lifetimes.

Once you choose a payout option and the contract begins, you cannot change it. The payment amount and structure are locked in for the life of the contract.

Tax treatment of fixed annuities

How you are taxed on a fixed annuity depends on whether you bought it with pre-tax money (such as money from a traditional IRA or 401(k)) or after-tax money (such as money from a savings account).

If you bought the annuity with pre-tax retirement account money, the entire payment you receive each month is taxed as ordinary income in the year you receive it. The insurance company will send you a 1099-R form each January showing how much you received.

If you bought the annuity with after-tax money, only part of each payment is taxed. The insurance company divides your premium into a taxable portion (the earnings) and a non-taxable portion (your original investment returned to you). Each month, you receive both portions, but only the earnings portion counts as taxable income. This is called the exclusion ratio, and the insurance company calculates it based on your life expectancy at the time you buy the contract.

If you withdraw money from a fixed annuity before age 59½, you may owe a 10 percent early withdrawal penalty on the taxable portion, in addition to ordinary income tax. Some annuities allow you to withdraw a small percentage each year (often 10 percent) without penalty, but this varies by contract.

Guarantees and insurance company risk

A fixed annuity is only as find as the insurance company that issued it. The company promises to make your payments even if its investments perform poorly, but if the company becomes insolvent, your payments are at risk. Most states have a guaranty fund that protects annuity owners if an insurance company fails, but the protection amount varies by state and is not unlimited. Many state guaranty funds cover up to $250,000 per person per company, though some cover more and some cover less.

Before you buy a fixed annuity, you can check the financial strength rating of the insurance company through agencies like A.M. Best, Moody's, or Standard & Poor's. These ratings indicate how likely the company is to meet its obligations. You can also contact your state's insurance commissioner's office to ask about the guaranty fund limits in your state.

Fixed annuities versus other retirement income options

A fixed annuity creates a may provide income stream, which is different from other ways to generate retirement income. With a 401(k) or IRA, you control the money and decide when and how much to withdraw, but you bear the investment risk and the money can run out. With a pension, your employer guarantees the payments, but you have no control over the amount and cannot pass unused money to your heirs (unless you choose a survivor option). With a fixed annuity, you trade control and flexibility for a may provide: the insurance company bears the investment risk, and you receive a predictable payment for life or a set period.

A fixed annuity also differs from a variable annuity, where your payment amount changes based on how the underlying investments perform. Variable annuities carry investment risk that you bear, not the insurance company. Fixed annuities carry no investment risk to you, but they also do not grow if markets rise — your payment is locked in when you buy the contract.

Inflation and fixed annuity payments

Because a fixed annuity payment never changes, inflation erodes its purchasing power over time. If you receive $1,000 per month and inflation averages 3 percent per year, that $1,000 will buy less each year. After 20 years of 3 percent inflation, your $1,000 payment will have the purchasing power of roughly $550 in today's dollars.

Some fixed annuities offer an inflation-adjustment option, where your payment increases by a set percentage each year (often 2 or 3 percent) or by the actual inflation rate. This option reduces your starting payment but protects you against inflation over time. Not all insurance companies offer this option, and it typically costs more upfront.

Frequently Asked Questions

Can I get my money back if I change my mind after buying a fixed annuity?

Most fixed annuities have a surrender period that lasts 5 to 10 years after purchase. If you withdraw money during this period, you pay a surrender charge (a percentage of the withdrawal amount). After the surrender period ends, you can usually withdraw your remaining balance without penalty, though you will owe income tax on any earnings. Some annuities allow a small annual withdrawal (often 10 percent) without penalty even during the surrender period.

What happens to my fixed annuity if I die before payments end?

It depends on the payout option you chose. If you selected a life annuity with no period certain, payments stop and your heirs receive nothing. If you selected life with period certain or period certain only, your heirs receive the remaining payments. If you selected joint and survivor, your spouse continues to receive payments. Check your contract to see which option you chose.

Can I use money from my IRA or 401(k) to buy a fixed annuity?

Yes. You can use pre-tax retirement account money to purchase a fixed annuity. The annuity becomes part of your retirement account, and the payments you receive are taxed as ordinary income. If you are under 59½, you may owe a 10 percent early withdrawal penalty on the taxable portion unless you meet an exception (such as the QLAC exception for may have access to longevity annuity contracts).

How is a fixed annuity different from a CD or savings account?

A CD or savings account returns your principal plus interest, and you can access your money at any time (though CDs charge a penalty for early withdrawal). A fixed annuity converts your lump sum into a stream of payments you cannot stop or change. You cannot get your principal back as a lump sum once payments begin. A fixed annuity is designed to create income for life or a long period, not to preserve a pool of money you can access.

Do I have to buy a fixed annuity all at once, or can I buy it gradually?

Most fixed annuities require a single lump-sum premium paid upfront. Some insurance companies offer deferred annuities where you make multiple payments over time before payments to you begin, but this is less common. Ask the insurance company whether they offer flexible premium options before you commit to a contract.