Is an Immediate Annuity for You?

With an immediate income annuity, you convert a lump sum into a stream of income that starts almost immediately. Having a guaranteed set stream of income for life provides valuable longevity insurance.

Technically, the product is a single premium immediate annuity, or SPIA, because it’s bought with a lump sum. Most often, though, it’s just called an immediate annuity.

The product is still timely despite historically low interest rates. Many retirees and pre-retirees are either tired of volatility or have already pulled funds from the market and are looking for predictable ways to generate guaranteed income for a specific period or a lifetime or joint lifetime. Only annuities can do that. A healthy person today can eliminate the risk of ongoing market volatility and ensure that their savings will last over a very long lifetime.

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The disadvantage is that you don’t have access to that money anymore. You’ve traded it in for a contract providing you with income that can last until you (and, optionally your spouse) die. But trading liquidity for guaranteed income brings many people peace of mind.

Many people use immediate annuities to cover their monthly core living expenses not covered by pensions and Social Security. They thus “pensionize” some of their assets to make sure that their core expenses are offset by guaranteed income. Remaining assets can then be placed in other instruments, such as stocks, accumulation focused indexed annuities and mutual funds. Devoting a portion of your portfolio to income production while retaining the balance in growth-oriented investments can be a great allocation strategy.

Here some key questions to ask when considering an immediate annuity.

Do I need more income right now?

If you need more income today or very soon, an immediate annuity can be a great solution, because it takes the risk out of your income stream. But, suppose you don’t need more income until you retire, say, five years from now. In that case, you’d be better off buying a deferred income annuity, with payments starting in five years. That way, you’ll get five more years of tax-deferred compounding in the annuity and bigger payments when you start.

Alternatively, you could buy a five-year fixed-rate deferred annuity — which offers a set interest rate for five years, much like a certificate of deposit — and convert it to an immediate annuity after five years. They are different products and work differently, even though they sound similar.

How long do I need income?

Most people choose a lifetime annuity to cover their needs in retirement. But you may need an annuity only for a set period. For instance, suppose you want to retire now but delay taking Social Security for eight years to let your benefit grow. You could buy an eight-year period-certain annuity to cover your income gap in the meantime.

How can I benefit from this particular annuity?

There is a wide variety of immediate annuities in the marketplace. So, you need to determine how and why a particular SPIA will meet your financial goals better than another.

For example, does the annuity offer the payout that you are seeking? Will it help you to achieve the income goals that you are opting for? Will it also cover your spouse or another individual if that’s what you had in mind? These are all things you need to know before committing.

Will my payments decrease if the financial markets go down?

No. An immediate annuity guarantees that your payments won’t change, regardless of the ups and downs of stock or bond markets. With an income annuity, your income payments are locked in and guaranteed. If you’re concerned about the effects of inflation on the purchasing power of your annuity income payments over time, you can add a Cost of Living Adjustment (COLA) rider when you purchase your annuity. A COLA rider will increase your annuity income amount each year by a fixed percentage that you define, typically 1%-4%. Be aware, adding a COLA rider will reduce, sometimes significantly, the amount of your initial income payments.

How soon can I begin receiving my income payments?

Your payments will begin immediately — or very soon after — you deposit your funds into the annuity. In most cases, you will receive your first income payment one month after your annuity is issued. However, if you don’t need the income right away, you can delay payments for up to one year.

How will my income payments be taxed?

It depends on the source of the money that you used for your deposit.

For example, if you used tax-qualified funds, such as those from a traditional IRA or a 401(k), you will be subject to taxes on the entire amount of your monthly payment. This is because none of that money has been taxed before. Since you got a deduction for contributing the money, it’s only fair that Uncle Sam should get his share when you take money out.

If, however, you used nonqualified funds from checking, savings, CDs or other nonqualified investments, this money has already been taxed. Therefore, only a part of your annuity income payment will be taxed when you receive it. A portion of each income payment that you receive from the annuity will be considered earnings, and a portion will be considered a return of principal. The earnings portion will be taxed as income, and the return-of-principal portion will be tax-free. Typically, the tax-free portion is larger.

How large will my income payments be?

It depends on your age and gender and which insurer issues the annuity. Here are a couple of examples as of June 15, 2020, for a $200,000 premium deposit of nonqualified funds:

Single Life Payout, Male age 67

Monthly lifetime income is $1,054.72, including $148.72 of taxable income and $906.00 of nontaxable income. After 18.4 years, at age 85, he will have recouped his initial premium deposit, and payments would then become fully taxable.

Joint Life Payout, Male age 67 / Female age 67

Monthly lifetime income payment is $875.80 ($157.64 taxable; $718.16 nontaxable).

After 23.2 years (at age 90) the couple will have recouped their initial premium deposit, and payments would become fully taxable.

What happens to my money if I pass away prematurely?

Immediate annuities can include a cash-refund feature that guarantees that your premium payment will not be lost if you pass away unexpectedly before you have received your deposit back. Therefore, if you pass away before your monthly income payments equal the full amount of your annuity purchase price, your named beneficiary will receive the difference. For example, if you deposited $100,000 into the annuity, and you had received a total of $50,000 in monthly income payments before passing away, then your beneficiary would receive the other $50,000 back tax-free, assuming you are using post-tax funds to purchase the annuity.

Most people chose this option. Choosing it does reduce your monthly payments. If having someone inherit your money isn’t important, you can skip this option.

Is there a limit to how many income payments you can receive?

Under the lifetime-income option, there is no limit to the number of income payments that you can receive. You will be guaranteed to receive your fixed monthly income payment for the rest of your life, no matter how long you live. This is valuable longevity insurance.

If you choose the joint income option, your spouse or another income recipient will also be able to receive regular monthly income payments for the remainder of his or her life, too. Monthly payments will be smaller than for a single life plan, but most married people choose the joint payment plan.