What is an immediate annuity?

While there are many variations of immediate annuities, the basic terms are simple: you give a single lump sum of money to the annuity issuer (an insurance company) which pays you an income for the rest of your life. Immediate annuities are appealing if you want a guaranteed income you cannot outlive.

An immediate annuity can shift longevity risk and inflation risk from the investor. The risks of losing a portion of your investment due to early death or failure of the annuity issuer (insurance company) still remain. Options, which address some of these concerns, include; receiving income for a set period of time, for the joint lives of you and another or income that adjusts to compensate for inflation.

How do immediate annuities work?

As the name implies, an immediate annuity begins to pay you a stream of income immediately. The amount of income you receive is based on a number of factors. First, immediate annuity payments are computed using actuarial tables. These tables take into account the annuitant's life expectancy. In the case of joint and survivor annuity options, an actuarial table using both the annuitant's age and the designated survivor's age is applied to calculate the amount of the periodic payments.

Second, the payments are based on the underlying interest rate the annuity issuer pays on the premium. The higher the interest rate, the higher the annuity payment will be. When current interest rates are lower, annuity rates are also lower.

Third, immediate annuity payments are determined according to the distribution option you chose. Longer payout periods, such as payments for life, will usually yield smaller payments than shorter, fixed payout periods, such as five or ten years. Joint distributions will also mean lower periodic payments.

Immediate annuity options

Life only annuity option

This option provides a guaranteed income for life. The income payments stop on the annuitant's death. This option will generally yield larger payments however, it is possible you may not live long enough to receive the return of all of your original investment.

Joint and survivor annuity option

This option provides a guaranteed income for as long as either joint annuitant is alive. When either annuitant dies, payments continue to be made for the life of the surviving annuitant. You can elect that these "survivor" payments remain the same, or be reduced to a percentage of the original payment. The joint and survivor option can also be added to the life with period certain option.

Joint and contingent survivor annuity option

This option provides a guaranteed income for as long as you or your joint contingent annuitant lives. If you, the primary annuitant, die first, payments will continue. However, they will decrease to 50 percent of the original payment amount. If the joint contingent annuitant dies first, annuity payments will continue to be received, without reduction, but only for the remainder of your life.

Period certain annuity option

Instead of making payments for the life(s) of the annuitant(s), this option provides a guaranteed payment for the period of time you specify (i.e., 5, 10, 15 or 20 years). If you die prior to the end of this period, your beneficiary will continue to receive payments for the remainder of the fixed period.

Installment or cash refund annuity option

If you are concerned about not living long enough to receive all of your investment back, this option provides an alternative. The annuity issuer not only guarantees payments for the annuitant's life, it also guarantees that the total of these payments will never be less than the premium you paid. If the annuitant dies before the original investment is repaid, the beneficiary will continue to receive payments until the full amount of the investment is paid back or a lump sum payment.

Life annuity with period certain option

With this option, the annuity issuer does not guarantee the return of your investment, rather it guarantees a minimum period of time during which payments will be made. If the annuitant dies prior to the end of the specified period, the payments will continue to be made to your beneficiary for the remainder of the period, but no longer.

Cost of living adjustment (inflation) rider

This rider reduces the initial payment you receive, but payments increase by one to five percent annually thereafter. This rider is intended to offset the effects of inflation on the income payments received.

Impaired risk (medically underwritten) rider

This option may be added to an immediate annuity or it may be sold as a separate immediate annuity. If you have a medical condition that reduces your "actuarial" life expectancy, the impaired risk rider allows you to receive a larger income payment for the same premium or the same income payment for a lower premium payment, based on your older, "actuarial" age as opposed to your actual age.

Commuted payout rider

This rider allows you to withdraw a lump sum from your immediate annuity in addition to the payments already being received. This option usually is available for a limited period and may be limited to a maximum dollar amount and/or a maximum percentage of the premium you paid to the annuity issuer.

Non-retirement strategies

While most financial professionals suggest that you do not devote all of your savings to an annuity, whether it is for retirement or other goals, there are strategies involving immediate annuities that may prove useful to you.

Fund long-term care or life insurance premiums

Many people have the need for long term care and/or life insurance, although many of these same people will not purchase either type of insurance because of its cost. If you have an asset, such as a CD, stocks, or mutual fund, which you do not intend to use or spend, consider liquidating that asset and investing it in a single premium immediate annuity. You can use the annuity payments to pay the premium cost of long term care insurance, life insurance, or both. This strategy allows you to convert an unused asset to one that is needed.

Provide income for a child with special needs or a spendthrift

Providing financial support for a child with special needs after you die is very important. Investing some of your estate proceeds in an immediate annuity can ensure a steady flow of income for the child's benefit for his/her entire lifetime.

What if you would like to leave a child an inheritance comparable in value to your other children, but you fear the child will squander or misuse the inheritance to his/her detriment. An immediate annuity can be used to control the flow of income to the spendthrift child.

In either case, you can direct in your will or trust that at your death, a specified amount of cash be used to purchase an immediate annuity for the benefit of your child. A "special needs trust" (or supplemental needs trust) is an estate planning tool that can help you provide for the needs of a disabled individual without jeopardizing his or her eligibility for government benefits. A spendthrift trust protects a trust beneficiary from themselves, creditors or other parties (e.g., a divorcing spouse). A spendthrift trust specifically prevents the beneficiary from transferring his or her interest, which may eliminate the ability of a creditor from accessing the interest. A qualified attorney can help you establish and administer these trusts.

Tax treatment of immediate annuities

Payments received are divided into two parts: a non-taxable portion that represents return of capital and a taxable portion that represents the earnings on the annuity. As a result, only a portion (i.e., the portion representing premiums paid) is excluded from your gross income. The portion of each annuity payment that is excludable is determined by multiplying each payment by an exclusion ratio. The fixed annuity exclusion ratio equals:

Your Investment in the Contract ÷ Expected Return = Exclusion Ratio.

Example: You have a fixed immediate annuity that pays you $200 a month for 20 years. Your expected return is $200/month x 20 years x 12 months/year = $48,000. If you have an investment in the contract of $24,000, your exclusion ratio is $24,000/$48,000 = 50 percent. As a result, 50 percent of each $200 payment ($100) is excludable from your gross income. The rest of the payment ($100) is treated as ordinary income.

If you have a life annuity, the expected return is calculated to your actuarial age.

Estate taxation of immediate annuities

If you select a single life only payment option, your annuity payments stop at your death. There are no estate tax implications because no part of the annuity is transferred.

If you buy a joint and survivor immediate annuity, at the death of one of the joint annuitants, payments will continue for the remaining life of the surviving annuitant. However, the value of the joint and survivor immediate annuity that the deceased annuitant paid for will be includable in the estate of the deceased annuitant. The amount included is the amount the same annuity issuer would charge the survivor for a single life annuity as of the date of the first annuitant's death. If the joint annuitant is the surviving spouse, the interest qualifies for the marital deduction. The surviving joint annuitant also receives an income tax deduction for any estate tax attributable to the annuity.

Strengths

•    Security and safety. An immediate annuity can provide a guaranteed income stream you can never outlive. If income is needed for a specific duration, guaranteed income payments can be provided for a fixed period of time.
•    Simplicity. You do not have to manage or worry about your investments, watch markets, report interest or dividends.
•    Tax treatment. Due to the exclusion ratio applied to determine that portion of your income payments that you treat as ordinary income, a portion of the payments you receive are treated as a return of your investment and are not treated as ordinary income.
Tradeoffs

•    If you chose a life only payout option, you may not live long enough to receive a return of all of your investment. If payments end at your death, the lack of income could adversely affect your family.
•    You relinquish control over the money you use to pay the immediate annuity premium. Should you need a large sum due to illness or other emergency, you may not be able to access it. Consider carefully the available immediate annuity options.
•    Your immediate annuity payments may not keep up with your spending needs or inflation. Since immediate annuities are not designed for maximum investment return, you may find that alternative investments pay a potentially higher yield for the same investment, but have proportionately higher risk.
•    Guarantees are subject to the claims-paying ability of the annuity issuer.

Who should consider an immediate annuity?

An immediate annuity can be a useful financial tool. You may want to consult with a financial professional if:

•    You want a stream of income you cannot outlive.
•    You have a sum of money that you would like to turn into a regular source of income and aren't interested in leaving the money to your heirs. Guaranteed income furnished by an immediate annuity may replace income provided by other assets, allowing those other assets to be left as a legacy or invested for growth.
•    You are uncomfortable with investments that have a significant risk of loss. To make your assets support your goals, you may have to invest at least some of your savings in equity investments. If subjecting your money to the risk of loss associated with investing in equities does not appeal to you, an immediate annuity provides a way to transfer that risk to an insurance company.
•    You expect to live for a long time. If you're healthy and have longevity in your family, an immediate annuity may be an appropriate choice for you.