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Immediate Annuities

Living longer than their money ranks high on the list of financial insecurities for most Americans.  Short of Social Security, there are few retirement income alternatives that guarantee an income source until death.  An immediate annuity issued by an insurance company is one of those alternatives.

There are two phases to an annuity.  During the accumulation phase the policy grows from tax-deferred interest or investment results credited to the policy by the insurance company.  The annuity becomes an immediate annuity when it is annuitized during the income phase, and begins paying out an income stream.

The owner of the annuity has a number of payout options.  A life-only option provides an income for the remainder of the owner’s life.  The owner can add a second life by selecting a joint and survivor option.  Or, a payout can be structured to pay for a set number of years.

Recently, I was talking with a single individual who posed the simple question, “How do I organize my money so that I spend my last dollar on my last day of life?”  Since neither of us could arrive at a firm determination as to when that last day would occur, we selected an immediate annuity as the solution.  As long as he lives, the insurance company is obligated to pay.  Upon his death, payments cease.

This example points out the very important fact that the owner of a life annuity and the insurance company have significantly different bets.  The insurance company is betting you will die sooner than expected, minimizing their payout.  You are betting you will live longer than expected, maximizing your benefits from the policy.

Payment amounts from an annuity are based on several factors.  First, if it is a life annuity, the shorter the life expectancy, the larger the payment.  An older individual will be paid more than a younger one.  (Life expectancy for annuity payout purposes is determined by insurance company experience and not a determination made as a result of a physical examination.)  If it is a joint and survivor policy, two lives are used and the amount of the payout is smaller than with a single life contract. 

Next, the insurance company makes an assumption regarding the interest or investment results that the remaining monies in the policy will earn prior to payout.  Lower interest rates or investment assumptions will generate a lower income stream.

If the annuity has been purchased with after-tax money the income stream comes with some significant tax advantages.  During the deferral phase of an annuity’s life, all earnings and investment results grow tax-deferred.  When the tax-deferred earnings are paid out, the tax collector wants his fair share. 

However, since an immediate annuity is paying back both principal and tax-deferred earnings, a portion of each payment is considered to be income and a portion considered to be tax-free return of principal.  The shorter the payout period, the greater the amount that can be excluded from tax.

Immediate annuities can be used in IRAs that require minimum distributions beginning at age 70 ½.  These minimum distribution rates are designed to distribute out the entire balance over a person’s lifetime.  However, as we live longer, the tables the IRS uses for this calculation are fast becoming obsolete, posing the real threat of outliving that retirement account.  However, if the retirement account is invested in an immediate annuity, a lifetime income stream can be assured, and the IRS will accept that amount as an acceptable minimum distribution.

by Wendell Cayton

Securities offered through Sigma Financial Corporation. A registered broker/dealer. Member FINRA & SIPC.

Planning Services offered through Sigma Planning Corporation, a registered investment advisor.

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Last modified: 05/11/10