Say you’re retired or very close to it. You have a healthy retirement account, a portion of which you want to shield from stock market losses. But money left in a CD or other saving account won’t earn much interest and will decrease in value every time you withdraw income. You have no idea how long those savings have to last.
The answer to this dilemma is an immediate annuity.
An immediate annuity is a contract with an insurance company. You give the company a one-time upfront payment, called premium, and in return you receive a fixed, guaranteed lifetime income stream. No stock market losses. No running out of retirement funds.
Immediate annuities are often compared to having a pension because they provide a lifetime income stream.
How immediate annuities work
Buying an immediate annuity is a simple process. You give an insurance company a one-time premium payment. This is usually a large sum, such as $50,000, $100,000, or more. The company subtracts fees from that premium, then calculates your lifetime income payment based on your age and gender. The older you are when you buy the annuity, the higher your income payments.
The annual income you receive from the annuity is called the payout rate, which is a percentage of the total amount of premium you paid upfront. For example, if you invested $100,000 in an immediate annuity with a 6 percent payout rate, you would receive $6,000 annually until you pass away. Comparing payout rates based on your current age is one way to decide which immediate annuity to buy.
Unlike life insurance, there are no health questions to answer and no underwriting of any kind. Once you pay the premium and the paperwork is processed, the income payments come on a monthly, quarterly or annual basis — whichever you prefer.
Making retirement income planning simpler
Immediate annuities simplify the process of planning for retirement income. When retirees depend on savings accounts and 401(k)s, there’s always the question of how much to safely withdraw. Take out too much and your retirement money could run out too soon. If your savings are invested in stocks or other vehicles that can lose value, the possibility of depleting your retirement funds increases.
With an immediate annuity, you know the exact amount of retirement income provided by the annuity. And you know that income will last until your death.
Immediate annuity disadvantages
One of the potential downsides of buying an immediate annuity is that the money is no longer accessible for, say, a medical emergency or other expense. Therefore, retirees should have other retirement assets, in addition to an immediate annuity, just in case.
And there exists the possibility you will pass away a few months or few years after purchasing the annuity. If so, you would not have received near the amount of income you put into the annuity. For some, this is a risk worth taking in exchange for the peace of mind of knowing they will have some form of income for the duration of their retirement. However, if you don’t have a long life expectancy, you probably do want to tie up your money in an annuity.
How annuity income is taxed
The tax treatment on your immediate annuity will depend on how you funded the contract. If you transferred money from a 401(k) or IRA, your annuity payments will be taxed as regular income. That’s because those instruments contain money you have not paid tax on.
If you use cash or other funds that have been taxed, than only a portion of your annuity income will be taxed. You would not pay tax on the portion of your payments that are considered a return of your original premium. The taxable portion is what your annuity pays above and beyond what you put into it.
Optional features and benefits
The above describes a traditional, fixed immediate annuity. Insurance companies offer some options to these products to make them more flexible. However, these options can increase the cost and/or lower the amount of income the annuity pays. These options include:
Variable payments. A variable immediate annuity allows you to invest your premium in mutual funds or other vehicles that can increase in value. If those investments grow, the amount of your income payments will grow as well. However, the opposite holds true if those investments decrease in value.
Payments for a set period instead of for life. Instead of receiving a lifetime income stream, you can opt to receive income for a fixed number of years, such as 10 years. Your income stream will be higher under this arrangement, but you lose the protection of guaranteed lifetime income.
You can also purchase a Life with Period Certain immediate annuity. Under this type of contract, you will receive a guaranteed lifetime income stream. But the contract will also guarantee a minimum number of payments. For example, a 5-year Period Certain annuity will guarantee a minimum of five years worth of payments. So if you were to pass away two years into the contract, your designated beneficiaries would continue to receive payments for three additional years. Because of the guaranteed minimum, your lifetime payments will be less than if you received just a Life Only annuity.
Joint annuities. You can purchase one annuity that provides guaranteed lifetime payments to you and your spouse. Payments continue after the death of one spouse until the second one passes away. Because this option costs more to the insurance company, your payment will be less than if only one of you received the lifetime income stream.
Inflation option. Some companies offer immediate annuities that will increase the income payments annually based on the rate of inflation. This is similar to how Social Security payments increase based on cost-of-living adjustments. This option will lower your initial income compared with a regular immediate annuity, but you will have a higher income stream in later years.
Return of Premium. This type of immediate annuity guarantees you or your beneficiaries will receive an amount equal to your initial premium, regardless of when you pass away.
Increased income for confinement or illness. Another new option some companies offer is an increase in the income payments, up to double, in the event you become terminally ill or confined to a nursing home or other care facility.