Jason has been involved in the financial services industry as an advisor and financial educator for more than ten years. Prior to joining Pure Financial Advisors, Jason taught in the Financial Planning program at the University of Redlands and helped design a similar program at Grantham University. He is especially happy to see former students [...]

Financial Educator Jason Thomas, CFP® from Pure Financial Advisors explains fixed indexed annuities and some of their advantages and disadvantages.

So what is a fixed indexed annuity? A fixed indexed annuity, a.k.a. an indexed annuity, is a type of annuity contract that has a performance based on a market index, rather than an established fixed percentage rate. There’s a lot to unpack in that statement. So let’s clarify some basic terms. An annuity is a series of payments, but most people when they think of an annuity are thinking of an annuity contract with an insurance company. There are different types of annuity contracts also, such as variable annuities and fixed annuities. But today we’ll be talking about the fixed indexed annuity.

Put simply, an equity index is a collection of companies used to determine the overall performance of the market overall, or a particular segment of it. Some of the most common are the Dow Jones Industrial Average or “the Dow.” The Standard and Poor’s 500 index, or the S&P 500, and the Nasdaq Composite index. Each of these common indexes averages the value of their components, although they don’t always do it in the same way, and they give us an idea of how that particular segment of the market is doing. Fixed indexed annuities use these or other indexes to determine how your account grows, or how it receives income over time. It’s important to understand that you do not own the underlying investments in the index. The insurance company uses the index as a crediting method.

There are other terms that may affect your return, such as caps, floors, participation rates, margins or spread. Is that point-to-point, is there a reset provision or a high water mark? Put simply, you don’t just get the return of the market without any downside. That is a bit of an oversimplification. So you’ll want to read your contract in full to find out how your specific return is actually calculated and how your crediting method works.

As with most financial products, there are advantages and disadvantages to fixed indexed annuities. Some of the advantages is that your principal may be protected if held beyond the surrender period, which is a point that you would have to pay a penalty to get out before. Taxes may also be deferred for taxable money in non-qualified accounts.

Some of the disadvantages of fixed indexed annuities are that the surrender periods can be lengthy and potentially fairly expensive. There can be very high commissions on these products, which sometimes means they can be oversold. The formulas to calculate your return can be very complex. So again, please read your entire contract.

And there are some tax disadvantages, such as beneficiaries inheriting their cost basis, rather than getting a step up, which would be the case for other types of assets such as stocks, for example. Also, the withdrawal of any gains will be taxed as ordinary income, not the capital gains rate.

If you have any additional questions regarding this or any other financial issues, please contact us at PureFinancial.com. Thanks for listening.

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