A fixed indexed annuity is an insurance contract that offers protection from market losses while giving you a chance to earn interest linked to a stock market index. It is often marketed as a way to get some market upside without downside risk. The tradeoffs are limits on gains, long surrender periods, and complex terms. This guide explains how these contracts work so you can evaluate an offer.
What a fixed indexed annuity is
A fixed indexed annuity (FIA) is a contract with an insurance company. You pay a lump sum or a series of premiums. During the accumulation phase, your account earns interest based partly on the performance of an index, such as the S&P 500. Your money is not invested directly in the index. Later, you can withdraw money, take a lump sum, or convert the value into a stream of income.
FIAs are regulated as insurance products by state insurance departments. Guarantees depend on the financial strength of the issuing insurer. State guaranty associations provide limited protection if an insurer fails, up to limits that vary by state.
How index crediting works
Each crediting period, often one year, the insurer measures the index’s change using a specified method. Your credited interest depends on that change and the contract’s limits.
Floor
Most FIAs have a floor of 0%, meaning that if the index falls, you receive no interest for the period but do not lose credited value because of index performance. Fees, rider charges, and surrender charges can still reduce your value.
Cap
A cap rate is the maximum interest you can earn in a period. If the cap is 8% and the index rises 15%, you are credited 8%.
Participation rate
A participation rate determines what portion of the index gain is credited. With a 60% participation rate and a 10% index gain, you are credited 6%.
Spread or margin
Some contracts subtract a spread from the index gain. With a 2% spread and a 10% gain, you are credited 8%. If the gain is less than the spread, you receive 0%.
Dividends usually excluded
Most indexes used in FIAs are price indexes, meaning they do not include dividends. Over long periods, dividends have made up a meaningful part of stock market returns, so this is another limit on upside.
Rates can change
Insurers generally can change caps, participation rates, and spreads at each renewal, subject to contract minimums. Ask what the guaranteed minimums are, not just the initial rates.
An example
Suppose you put $100,000 into an FIA with an annual point-to-point S&P 500 strategy and a 9% cap.
- Year 1: Index rises 14%. You are credited 9%, or $9,000. Value: $109,000.
- Year 2: Index falls 12%. You are credited 0%. Value: $109,000.
- Year 3: Index rises 5%. You are credited 5%, or $5,450. Value: $114,450.
Without fees or riders, the value never declined because of the index, but you also gave up gains above the cap. A direct index investment would have had different results, including losses in the down year and dividends.
Surrender charges
FIAs are designed as long-term contracts. Most impose surrender charges if you withdraw more than a set amount, often 10% per year, during the surrender period, which commonly lasts several years to a decade or more. Charges typically decline each year. A market value adjustment may also apply.
Before buying, make sure you will not need the money during the surrender period.
Bonus annuities
Some FIAs offer a premium bonus, adding a percentage to your initial deposit. Bonuses often come with longer surrender periods, lower caps, or vesting schedules. Compare the contract as a whole rather than focusing on the bonus.
Income riders
Many FIAs offer optional guaranteed lifetime withdrawal benefit riders, often for an annual fee. The rider creates an income base that grows at a stated roll-up rate and is used to calculate guaranteed lifetime withdrawals. The income base is not your cash value and generally cannot be withdrawn as a lump sum. Read how withdrawals are calculated, how fees are charged, and what happens if you take more than the allowed amount.
Taxes
- Tax deferral: Earnings in a non-qualified annuity grow tax-deferred until withdrawn.
- Ordinary income: Earnings are taxed as ordinary income, not capital gains, when withdrawn.
- Withdrawal order: For non-qualified annuities, withdrawals are generally treated as earnings first.
- Early withdrawal penalty: Earnings withdrawn before age 59½ may face an additional 10% tax unless an exception applies.
- Qualified annuities: If an FIA is held inside an IRA, IRA rules apply, including required minimum distributions.
Since an IRA is already tax-deferred, an annuity inside an IRA does not provide additional tax deferral.
Free-look period
States require a free-look period, often 10 to 30 days, during which you can cancel and get your money back. Use this period to read the contract carefully.
Who may consider an FIA
An FIA may suit someone who:
- Wants principal protection from index losses
- Accepts limited upside in exchange
- Will not need the money during the surrender period
- Values guaranteed lifetime income options
- Has already maximized other tax-advantaged accounts if buying a non-qualified annuity
It may not suit someone who needs liquidity, wants full market growth, or is uncomfortable with complex terms.
Questions to ask before buying
- What are the current and guaranteed minimum caps, participation rates, and spreads?
- How long is the surrender period, and what are the charges each year?
- What fees apply for riders?
- What is the insurer’s financial strength rating?
- How is the agent compensated?
- What happens to the contract when I die?
Suitability and complaints
Many states have adopted best-interest standards for annuity sales based on NAIC model rules. If you believe an annuity was sold inappropriately, contact the insurer and your state insurance department.
Comparing crediting methods
Contracts often offer several strategies, and you may be able to split money among them.
- Annual point-to-point: Compares the index value at the start and end of each contract year.
- Monthly average: Averages index values over the year, which can smooth volatility but may reduce gains.
- Monthly sum or monthly cap: Adds monthly changes, each subject to a monthly cap, with no limit on negative months, which can result in zero credit even in an up year.
- Multi-year point-to-point: Measures change over two or more years, sometimes with higher caps or participation rates.
- Volatility-controlled indexes: Some contracts use proprietary indexes designed to limit volatility, often paired with high participation rates. Their track records may be short or back-tested.
- Fixed account: Pays a declared interest rate for the year.
FIAs vs. other options
Compared with a certificate of deposit, an FIA offers potential index-linked interest but less liquidity and no FDIC insurance. Compared with a multi-year guaranteed annuity, an FIA offers less certainty but more potential upside. Compared with direct investing in an index fund, an FIA offers downside protection but caps gains, excludes dividends, and restricts access.
What happens at death
Most FIAs pay a death benefit to named beneficiaries, often equal to the account value without surrender charges. Beneficiaries generally owe ordinary income tax on the earnings portion. Spouses may be able to continue the contract.
Related reading: Backdoor Roth IRA: Step-by-Step Rules, the Pro-Rata Trap, and Reporting on Form 8606 and Solo 401(k): Contribution Rules for Self-Employed Savers.
Frequently Asked Questions
Can you lose money in a fixed indexed annuity?
Index losses are typically limited by a 0% floor, but surrender charges, market value adjustments, and rider fees can reduce your value.
What is a cap rate?
It is the maximum interest you can be credited in a crediting period, regardless of how much the index rises.
Are fixed indexed annuities taxed?
Earnings grow tax-deferred and are taxed as ordinary income when withdrawn. Early withdrawals before 59½ may face a 10% additional tax.
What is an income rider?
An optional feature, usually for a fee, that guarantees lifetime withdrawals based on an income base.
How long is the surrender period?
It varies by contract, commonly several years to a decade or more.
This article is for general informational purposes only and is not legal, medical, tax, or financial advice. Rules vary by state and change over time; confirm details with the relevant agency or a licensed professional.
