What’s the difference between a fixed and variable annuity?

A fixed annuity is a contract offered by an insurance company that is much like a bank CD. You deposit a certain amount of money and the insurer agrees to pay a certain interest rate over a specified period of time.

But there are a couple of twists that make a fixed annuity slightly different. Unlike with a bank CD, the interest you earn in a fixed annuity isn’t taxed until you withdraw the money from the annuity. If you withdraw those fixed-annuity interest earnings before age 59-1/2, however, you’ll not only pay income tax on the growth, but a 10 percent penalty. This is because annuities are considered tax-deferred retirement vehicles.

In addition, insurers typically charge an early withdrawal charge for withdrawals made within the first seven to 10 years that you own the annuity. These early withdrawal charges can start as high as 10 percent, but usually decline by a percentage point or so until they disappear after seven to 10 years.

A variable annuity differs from a fixed annuity in that inside a variable annuity are investments similar to mutual funds.  These investments are called subaccounts, and the value varies based on the performance of the investments.  Variable annuities have the same tax treatment as fixed annuities, in that earnings are tax deferred until they are withdrawn from the account.

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