Yes, annuities do pay interest, but how much and by what method depends on the type of contract. A fixed annuity credits a set percentage the insurer guarantees in writing. A fixed indexed annuity ties interest to a market benchmark with a ceiling on gains and a floor at zero. A variable annuity doesn’t pay interest in the traditional sense at all; your money rises and falls with investment sub-accounts. All three grow tax-deferred, so you owe no income tax on the earnings until you take money out.
Fixed Annuities: A Guaranteed Rate
A fixed annuity works the way most people picture interest. The insurance company takes your premium, invests it primarily in bonds, and credits your account at a stated annual percentage regardless of how markets perform.
The contract locks in an initial rate for a set number of years. Some products guarantee the initial rate for one year; others hold it for the entire surrender period.1National Association of Insurance Commissioners. Consumer Guide to Fixed Annuities When the initial guarantee ends, the insurer sets a renewal rate based on prevailing bond yields. That renewal rate can move up or down, but it can never fall below the guaranteed minimum written into your contract.
Interest typically compounds annually. If you leave credited interest in the account, each year’s interest earns interest the next year, and over a long accumulation period that adds up.
Multi-Year Guaranteed Annuities (MYGAs)
A MYGA is the fixed-annuity subcategory that most resembles a bank CD. You deposit a lump sum, the insurer locks in a guaranteed rate for a chosen term (typically three to ten years), and your money compounds at that rate until the term ends. Unlike a CD, the interest inside a MYGA grows tax-deferred, so you don’t pay income tax each year on what’s credited. MYGAs appeal to people who want a predictable return with no exposure to stock-market risk.
The Guaranteed Minimum Rate
Every fixed annuity contract carries a guaranteed minimum rate that acts as a floor. Even in a poor bond market, your account can’t earn less than that percentage. The floor is set under state insurance regulations based on the NAIC’s Standard Nonforfeiture Law for Individual Deferred Annuities.2National Association of Insurance Commissioners. Project History – Standard Nonforfeiture Law for Individual Deferred Annuities Model 805 Many insurers set their contractual floor above the regulatory minimum, but the guaranteed minimum in your contract can still be well below the rate you’re initially credited.
Fixed Indexed Annuities: Interest Tied to a Market Index
A fixed indexed annuity (FIA) links your interest to the performance of a market index, often the S&P 500, without actually investing your money in stocks. At the end of each crediting period, the insurer applies a formula to the index’s movement and credits interest accordingly. If the index falls, your credited interest for that period is simply zero. Your principal doesn’t drop.
The trade-off for that downside protection is a cap on the upside, applied through one or more contract mechanisms:
- Cap rate. A ceiling on interest for a single crediting period. If the index gains 15% and your cap is 8%, you’re credited 8%.
- Participation rate. The share of the index gain that counts. A 70% participation rate on a 10% index gain credits 7%.
- Spread (or margin). A flat percentage subtracted from the index gain. A 10% index gain with a 2% spread credits 8%.
Some contracts use one of these; others combine two. The insurer can adjust caps and participation rates at each contract anniversary within limits set by the contract, so the terms you start with may not be the terms you have five years in.
The most common crediting method is annual point-to-point: the insurer compares the index level at the start and end of a one-year window. Any gain (after the cap, participation rate, or spread) is locked into your account permanently. A loss produces zero interest for that period but doesn’t erase what you’ve already earned.
Variable Annuities: Returns, Not Interest
Variable annuities don’t pay a guaranteed rate. Your premium goes into sub-accounts, which are investment portfolios similar to mutual funds. Account value rises and falls daily with market performance, and you bear the investment risk.
Variable annuities also carry layered fees that reduce whatever the sub-accounts return:
- Mortality and expense (M&E) risk charge. Compensation for the insurer’s contract guarantees, commonly around 1.25% of account value per year.
- Administrative fees. Often around 0.3% annually or a flat dollar amount.
- Sub-account management fees. Each underlying portfolio charges its own expense ratio.
Total annual charges on a variable annuity can reach 2% to 3% or more of account value, substantially higher than a comparable mutual fund or ETF.
Because the base contract has no interest floor, many owners buy optional riders such as a guaranteed minimum income benefit, which sets a baseline for future income payments regardless of sub-account performance.3Pacific Life. Optional Benefit Fees for Variable Annuities Rider fees stack on top of the base contract charges.
Tax Deferral and How Withdrawals Are Taxed
During the accumulation phase, all interest, gains, and dividends inside an annuity compound without a current tax bill. You owe nothing until you withdraw funds or begin income payments. This applies whether the annuity is held inside a qualified retirement account or purchased with after-tax dollars as a non-qualified contract.
When you take money out of a non-qualified annuity before the annuity starting date, the IRS treats the withdrawal as coming from earnings first, not principal. Early withdrawals are almost always fully taxable until you’ve pulled out all the accumulated interest. Annuity gains are taxed as ordinary income, not at the lower long-term capital gains rate, regardless of how long you held the contract.4Internal Revenue Service. Publication 575 – Pension and Annuity Income
The 10% Early Withdrawal Penalty
If you withdraw taxable gains before age 59½, you generally owe an additional 10% federal tax on top of ordinary income tax. Exceptions include distributions after the death of the contract holder, distributions due to disability, and a series of substantially equal periodic payments over your life expectancy.5Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Immediate annuities are also exempt from the penalty.
What Determines the Rate You’re Offered
Several factors influence the rate an insurer quotes on a new contract:
- Bond yields and Federal Reserve policy. Insurers invest largely in bonds, so prevailing rates are the biggest driver. Higher yields let insurers credit more.
- Surrender period length. Longer surrender periods usually mean higher rates, because the insurer can invest your premium in longer-term, higher-yielding bonds.
- Premium size. Larger deposits sometimes qualify for a slightly higher rate.
- Your age at purchase. Age can affect the rate because it changes the insurer’s assumptions about how long it will hold the funds before paying income.
In higher-rate environments, fixed annuity rates have reached 4% to 5% or more for multi-year terms. Fixed indexed annuity caps and participation rates also tend to be more generous when bond yields are strong.
Getting Your Money Out
Most deferred annuities charge a surrender fee if you take out more than a set amount during the early contract years. A typical schedule starts at 6% to 7% of the withdrawn amount in year one and drops by roughly one percentage point each year until it reaches zero, often after six to eight years. Terms vary, so read the surrender schedule before signing.
Most contracts allow a free withdrawal of up to 10% of account value each year without a surrender charge. Anything above that gets hit with the applicable percentage for that contract year.
The Free-Look Period
After buying an annuity, you generally have a free-look period during which you can cancel and receive a full refund of your premium. States set the minimum length, typically at least 10 days and sometimes 20 or 30. Cancelling within that window avoids any surrender charge.
State Guaranty Association Coverage
Annuities are not covered by FDIC insurance, because they’re insurance products rather than bank deposits. Every state operates a life and health insurance guaranty association that steps in if an insurer becomes insolvent. In most states, the standard coverage limit for an individual annuity is up to $250,000 in present value of annuity benefits, with a few states setting higher limits.6NOLHGA. FAQs: Product Coverage The limit applies per insurer, so spreading larger amounts across multiple highly rated companies is one way to stay within coverage. Check your state’s specific limits before committing a large premium.