Where the money goes
A fixed indexed annuity is a contract with an insurance company. You pay a premium, usually from savings or a rollover; the carrier holds it in its general account, backed mostly by bonds, and promises that the contract value won't fall because of the market. Interest is credited to your contract based on the movement of an index, most often the S&P 500, but you don't own the index and the money never goes into stocks.
How the interest is figured
The most common method is annual point-to-point: the carrier compares the index on your contract anniversary with the index a year earlier.
- If the index rose, you're credited the gain up to a cap (say 8%), or a share of it set by a participation rate (say 60% of the gain), sometimes minus a spread.
- If the index fell, you're credited 0%. Your contract value and every prior year's credit stay where they were.
- The new value becomes the base for the next year. Gains lock in; losses don't accumulate.
| Index year | Credited, with an 8% cap |
|---|---|
| +15% | +8% |
| +5% | +5% |
| −20% | 0% |
| +12% | +8% |
Caps and participation rates are set by the carrier for each term and can change at renewal within limits stated in the contract. A high cap today isn't a promise about next year; the guaranteed minimums are.
The four things in the fine print
- Surrender period and charges: usually 5 to 10 years, with a charge that declines each year on withdrawals above the allowance. This is the price of the guarantee.
- Free-withdrawal allowance: commonly 10% of the contract value each year without a surrender charge, after the first year.
- Riders: a lifetime-income or enhanced death-benefit rider adds a guarantee and usually a fee of about 1% a year. Worth it for some, not for all.
- The carrier: the guarantee is only as good as the company behind it. Agents compare financial-strength ratings from AM Best and others; state guaranty associations add a backstop with limits that vary by state.
Taxes
Interest grows tax-deferred. Money from a 401(k) or IRA can usually move in as a direct transfer without tax. Withdrawals of gains are taxed as ordinary income, and withdrawals before age 59½ may carry a 10% federal penalty on top. Required minimum distributions still apply to money that came from a retirement account.