A fixed annuity pays an interest rate the insurance company guarantees. An indexed annuity credits interest based in part on how a market index performs, usually with limits on how much of any gain you receive. In short, fixed annuities trade upside for predictability, and indexed annuities offer a chance at higher credited interest in exchange for more complexity and more rules to understand.
Neither type is right for everyone, and both come with surrender charges and tax rules that matter. This guide explains how each works, how they compare, and what to ask before you buy.
What Is a Fixed Annuity?
With a fixed annuity, FINRA explains, the insurance company guarantees both the interest rate and the payout. The rate is often locked in for a set number of years and then resets periodically. Because the rate doesn’t depend on the stock market, the growth is predictable, although payouts typically don’t rise with inflation.
What Is an Indexed Annuity?
An indexed annuity is a contract with an insurance company that, in the words of the SEC’s Investor.gov bulletin, generally promises returns linked to the performance of a market index. Your money isn’t invested in the index itself. The index is a formula the insurer uses to decide how much interest to credit, using a method such as comparing the index level at the start and end of a period (point-to-point) or averaging index levels during the period.
Several features limit how much of an index gain you receive:
- Participation rate. The share of the index gain that is credited. With a 75% participation rate, a 10% index gain credits 7.5%.
- Rate cap. The maximum return the contract can credit. With a 7% cap, a 12% index gain credits 7%.
- Spread or margin. A percentage subtracted from the gain. With a 3% spread, a 9% gain credits 6%.
The SEC adds that indexed annuity returns typically exclude dividends, and that contracts commonly let the insurer change some of these features periodically, which can affect what you earn.
FINRA describes indexed annuities as carrying more risk than fixed annuities and less than variable annuities. A traditional indexed annuity pairs a minimum guaranteed value with index-linked interest. FINRA notes that the minimum is typically at least 87.5% of the premium, growing at 1% to 3% interest. A newer category, the registered index-linked annuity, uses a buffer or floor that limits losses rather than eliminating them, so these products can lose value. Always ask which kind you’re looking at.
Fixed vs. Indexed Annuities: Side by Side
| Fixed annuity | Indexed annuity | |
|---|---|---|
| How interest is set | A stated rate guaranteed by the insurer | Linked to an index, then reduced by caps, participation rates or spreads |
| Upside | Limited to the stated rate | Potentially higher in strong index years, but capped |
| Predictability | High | Lower; credited interest varies year to year |
| Complexity | Simple | More complex, with several formulas to understand |
| Insurer can change terms | Rate resets after the guarantee period | Some crediting features can change periodically |
| Surrender charges | Commonly apply | Often six to ten years or longer, per the SEC |
What Fixed and Indexed Annuities Have in Common
- Tax-deferred growth. Earnings aren’t taxed until you withdraw them. With a non-qualified annuity, FINRA says withdrawn gains are taxed as ordinary income.
- An early-withdrawal tax. Withdrawals before age 59½ may trigger an additional 10% federal tax on top of regular income tax.
- Surrender charges. Pulling money out during the surrender period can cost you. Most states give a free-look period, generally 10 to 30 days, to cancel after buying.
- No FDIC insurance. Guarantees are only as strong as the insurance company behind them. FINRA notes that state guarantee associations may offer some protection if an insurer fails.
Who Each Type Tends to Suit
Fixed annuities tend to appeal to people who put predictability and simplicity first and are comfortable with a stated rate. Indexed annuities tend to appeal to people who are comfortable with complexity, want the chance at higher credited interest than a fixed rate offers, and understand they are accepting caps, other limits and a long surrender period in exchange.
Neither is a fit for money you may need soon. The right choice depends on your time horizon, your income needs, your tax situation and how much complexity you want to take on, so it’s worth talking through your situation with a licensed agent and a tax professional.
Questions to Ask Before You Buy
- What type of annuity is this, and is it a security with a prospectus?
- Which crediting features apply (cap, participation rate, spread), and what can the insurer change later?
- What is the surrender schedule, and how much can I withdraw without a charge?
- What commissions and fees are involved, and how much of my money goes to work for me?
- What is the minimum guarantee, and how is it calculated?
- How is the insurer rated for financial strength?
How Indexed Interest Is Calculated
An indexed annuity ties its credited interest to a market index, but the insurer limits how much of the index gain you receive. The SEC’s investor bulletin on indexed annuities gives these examples:
| Feature | How it works | Example |
|---|---|---|
| Participation rate | The share of the index gain that is credited | 75% participation on a 10% index gain credits 7.5% |
| Cap rate | The maximum return that can be credited | A 7% cap on a 12% index gain credits 7% |
| Spread (margin) | A set percentage subtracted from the gain | A 3% spread on a 9% gain credits 6% |
| Combined | Features can work together | 75% participation and a 3% spread on a 10% gain credits 4.5% |
Index gains are generally calculated without dividends, and insurers can change features such as the cap rate over time, so ask what the renewal terms are. A related product, the registered index-linked annuity, can lose value because it offers a buffer or floor instead of a guarantee. A 10% buffer means the insurer absorbs the first 10% of a decline and you bear the rest. Indexed annuities that are not securities typically include minimum guarantees that limit, and in many cases eliminate, the chance of loss.
Surrender Charges and Access to Your Money
Surrender periods typically last six to ten years or longer, and the charge reduces what you receive if you withdraw more than the contract allows. This schedule is illustrative only, since every contract differs:
| Contract year | 1 | 2 | 3 | 4 | 5 | 6 | 7 |
|---|---|---|---|---|---|---|---|
| Illustrative surrender charge | 7% | 6% | 5% | 4% | 3% | 2% | 1% |
Under this example, taking out $10,000 above the free amount in year 2 would trigger a charge of about $600. Many contracts allow limited withdrawals each year without a charge, so confirm yours. Withdrawals before age 59½ may also trigger a 10% federal tax penalty, in addition to ordinary income tax on the earnings.
Annuities vs. Bank CDs
| Feature | Fixed annuity | Fixed indexed annuity | Bank CD |
|---|---|---|---|
| Protection | Backed by the insurer, not FDIC insured | Backed by the insurer, not FDIC insured; non-securities contracts include minimum guarantees | FDIC insured up to $250,000 per depositor per bank |
| Return | Declared rate for a set period | Linked to an index through caps, participation rates or spreads | Fixed rate for the term |
| Taxes | Growth is tax-deferred, then taxed as ordinary income when withdrawn | Growth is tax-deferred, then taxed as ordinary income when withdrawn | Interest is generally taxed each year |
| Early access | Surrender charges | Surrender charges | Early withdrawal penalty |
Check the Insurer, Not Just the Product
An annuity’s guarantees are only as strong as the insurer that issues it, because payments depend on the company’s ability to pay. Look at independent financial strength ratings for the carrier, and ask how your state’s guaranty association would protect you if an insurer failed, since those protections vary by state and have limits.
Talk Through Your Retirement Options
Annuities are one tool among several for retirement income. Our licensed agents can compare fixed and indexed annuity options from multiple carriers at no cost to you and walk through the terms in plain language.
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Annuities are insurance products, are not FDIC insured, and may carry surrender charges. Features, rates and availability vary by carrier and state. This article is general information and is not tax, legal or investment advice.
Frequently Asked Questions
What is the main difference between a fixed and an indexed annuity?
A fixed annuity earns a stated interest rate the insurer guarantees. An indexed annuity credits interest linked to a market index, subject to limits such as caps, participation rates and spreads.
Can you lose money in an indexed annuity?
Traditional indexed annuities carry a minimum guaranteed value, which FINRA says is typically at least 87.5% of the premium at 1% to 3% interest, and you can also lose value through surrender charges if you withdraw early. Registered index-linked annuities can lose value because their buffers and floors only limit losses.
Are annuity earnings taxable?
Earnings grow tax-deferred. When you withdraw gains from a non-qualified annuity they are taxed as ordinary income, and withdrawals before age 59 and a half may also face a 10% federal tax.
What is a surrender charge?
A penalty for withdrawing money or canceling during the surrender period. For indexed annuities the SEC says the period typically lasts six to ten years or longer.
Which is better, a fixed or an indexed annuity?
Neither is better for everyone. Fixed annuities favor simplicity and predictability, while indexed annuities offer a chance at higher credited interest with more complexity. The right fit depends on your goals, time horizon and tax situation.
What is a participation rate in an indexed annuity?
It is the percentage of the index gain that gets credited to your contract. For example, a 75% participation rate on a 10% index gain credits 7.5% to your annuity.
What is the difference between a cap rate and a spread?
A cap rate sets the maximum return the contract can credit in a period. A spread is a set percentage subtracted from the index gain before it is credited. Some contracts use one, some use both, and some combine either with a participation rate.
How long do annuity surrender charges last?
Surrender periods typically last six to ten years or longer, with the charge usually declining each year. Many contracts allow limited penalty-free withdrawals, so check the free withdrawal terms in your contract before you buy.
