How Does a Fixed Annuity Work?
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Annuities Defined
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There are two basic types of annuities, fixed and variable. The main difference between the two products is risk tolerance. A fixed annuity guarantees a fixed amount of interest in return for use of funds; the return is fixed. A variable annuity can have fluctuating returns, but might have a bigger payoff in return for this added risk; the return is variable. The fixed annuity is similar in payment structure and risk tolerance to a certificate of deposit (CD), while the variable annuity is similar to investing in a mutual fund.
Fixed Annuities - A Deeper Dive
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Fixed annuities are guaranteed by the insurance company over a specific term. The insurance company can never decline payment and takes on the associated profit or loss of the investment. The interest paid on the account generally accrues annually and is tax deferred until withdrawn. In general, fixed annuities offer a one-year flat rate. This rate may change each year, but a few insurance companies may offer a locked-in feature for the entire period (multi-year guarantee annuities). Claimants may withdraw up to 10% of the balance every year, but more than 10% will result in a penalty.
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Best of Both Worlds
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An example of an insurance product which shares attributes of both a fixed and variable annuity is an Indexed annuity where your principal is guaranteed (fixed principal repayment), but your interest each year is based on a specific Index like the Dow or S&P 500 Index (variable return). The result is a product with the principal guarantee of a fixed annuity and the potential price appreciation of a variable annuity.
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