Indexed Annuities

Everything You Need To Know about Fixed Indexed Annuities

(Maybe even a little bit more)

Indexed annuities

Uncle Sam wants us to save for retirement. That’s why annuities have special features and tax benefits. Where there are tax benefits, there are usually strings attached. Annuities are no exception.

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So you want to know about fixed index annuities? Here’s everything you ever wanted to know, and maybe a little more.

First Things First... What’s an Annuity?

Annuities are policies issued by insurance companies. They pay a regular guaranteed income for life or a period of years. You buy an annuity policy by making a single payment or a series of payments.

  • Deferred annuities accumulate money for a period before the policy pays income.
  • Immediate annuities start paying income right away.
  • Traditional qualified annuities are part of a pension plan or IRA. They are purchased with before-tax dollars. Roth-qualified annuities are part of a Roth IRA or pension plan. They are purchased with after-tax dollars. Non-qualified annuities are personally owned and paid for with after-tax dollars.

Owners, Annuitants, and Beneficiaries

An annuity policy is a contract between the insurance company and these folks. The owner has the sole right to the values and payments in the contract. The owner decides who the annuitant and beneficiaries are. The age and sex of the annuitant are how the insurance company determines the amount of income. 

The annuitant and owner don't have to be the same. The beneficiary receives the proceeds at the death of the owner or annuitant. The insurance company issues the policy and has to honor the promises in it. Guarantees in the policy are only as good as the financial ability of the insurance company to pay claims.

How Does a Fixed Indexed Annuity Work?

Fixed index annuities offer growth potential without stock market risk. Index accounts credit some of the gains of a market index like the S&P 500 and none of the losses. The portion of gains credited is measured by:

  • Participation rate: A percentage of the gain
  • Cap Rate: Gains up to a stated percentage

The gains are also measured for a term, usually 1 to 5 years. Finally, the gains are measured by a method.

  • Point to point: The market index value at the end of the term measured against the market value at the beginning of the term.
  • Monthly average: The market index value in the first month measured against the average monthly index value during the term.
  • Trigger point:  A fixed rate of interest is credited if the index rises above a stated level by the end of the term.

What If the Insurance Company Goes Bankrupt?

Insurance companies that sell fixed index annuities are regulated by each of the 50 state insurance departments. These departments have financial standards for licensed companies. Each state has guarantee funds to reimburse policyholders if the insurance company fails. The limits for each state are different.

Financial ratings of insurance companies are available from A.M. Best, Fitch, Moody’s and Standard & Poor.

Highest Ability To
Meet Obligations
Medium Ability To
Meet Obligations
Lowest Ability To
Meet Obligations
A.M. BestA++ to A-B++ to B-C++ to C-
Moody’sAaa to AaA to BaaBa to Caa
FitchAAA to AA-A+ to BBB-BB+ to CC

What Are the Features of an Indexed Annuity?

Indexed annuities offer a wide choice of benchmark indexes and performance measures. 

  • Guaranteed lifetime income: You can select from 6 or more income options. All of them 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.

How Much Does a Fixed Index Annuity Cost?

  • 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 0 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.

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 LifetimeAt DeathAdvantagesDisadvantages
Life Pays income for annuitant’s life.NoneHighest incomeNo refund of unused principal
Life and 10 Years CertainPays income for life. Not less than 10 yearsBalance if death occurs before the end of 10 yearsProtection for beneficiariesLower income
Life and 20 Years CertainPays income for life. Not less than 20 yearsBalance if death occurs before the end of 20 yearsProtection for beneficiariesLower income
Life wIth Cash RefundPays income for life. Payments are the least specified refund amount.Balance of refund amountProtection for beneficiariesLower income
Period CertainPays income for a specified number of years.Balance of paymentsUseful for certain planning purposesOutliving income
Joint & Survivor 100%Pays income for longer of two livesNo further payments at 2nd deathSurviving spouse continues to receive income for lifeLower income
Guaranteed Lifetime Withdrawal Benefit Single LifePays income for annuitant’s life.Balance of accountAccess to account values, death benefitIncome taxed as withdrawals
Guaranteed Lifetime Withdrawal Joint LifePays income for lifetimes of annuitant and 2nd lifeBalance of account at 2nd deathAccess to account, death benefitIncome 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 tax treatment of retirement annuities. 

ContributionsAfter-tax. UnlimitedPre-tax. Limits for IRAs and qualified plans apply.After-tax. Limits for IRAS and qualified plans apply.
Growth Tax-deferredTax-deferredTax-deferred
Surrender Gain is taxed at ordinary rates.All proceeds taxableTax-free
Annuity Income Partially taxable at ordinary rates100% taxable at ordinary ratesTax-free
Withdrawals Withdrawals are gain first. Gain is taxed at ordinary rates.100% taxable at ordinary ratesTax-free
Loans Loans are considered withdrawals. Gain first is taxed at ordinary rates.IRA loans not permitted. Pension plans may have exceptions for home purchase and loans repaid in 5 years.IRA loans not permitted. Pension plans may have exceptions for home purchase and loans repaid in 5 years.
Death BenefitsGain is taxed at ordinary rates. Proceeds will be taxed as "gain firs.t"Rules for inherited traditional IRAs and qualified plans apply.Rules for inherited Roth IRAs and plans apply.
Sales Proceeds in excess of basis taxed at ordinary rates.N/AN/A
Penalties10% for withdrawals before age 59-1/210% for withdrawals before age 59-1/210% for withdrawals before age 59-1/2. Penalty for withdrawals prior to  end of the 5th year

What Happens to the Money in a Fixed Index Annuity When You Die?

If you die during the deferral period, your beneficiary will receive the account value. If you die 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?

Fixed index annuities are financial tools. Whether they are right for you depends on the job you want them to do. Here are some considerations:

  • Tax-Deferred Growth is a major benefit of 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”?
  • Fixed index annuities have surrender and tax penalties. Do you have adequate resources for emergencies and other short-term needs?
  • Fixed indexed annuities can guarantee an income for life. Do you want a fixed guaranteed income for life instead of income that may benefit from market returns?

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 A.M. Best, Moody’s, Standard & Poor, and Fitch. Each has differences in their methodologies and rating designations.

The rating each service assigns reflects their opinion about the insurance company's ability to pay claims. Look for high-quality ratings from at least 2 of the 4.

Highest Ability To
Meet Obligations
Medium Ability To
Meet Obligations
Lowest Ability To
Meet Obligations
A.M. BestA++ to A-B++ to B-C++ to C-
Moody’sAaa to AaA to BaaBa to Caa
FitchAAA 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.

Is it a market value adjustment (MVA) policy? The MVA can have a positive or negative effect if you withdraw money or surrender the policy early.

What Next?

Fixed index annuities can be an important part of your retirement plan. While they have many features and benefits, they are not for everyone. Talk to your independent insurance agent. They can help you decide if a fixed index annuity is right for you.

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