13 min read
This story originally appeared on Due
Last week I turned on the air conditioner for the first time this year. Much to my chagrin, it wasn’t working properly. So, I had to have someone come out and fix it — unless I wanted to sweat my keister off all summer.
But, what if I didn’t have the money on hand to repair the AC? I would either have to wait until I had the money or borrow the money from a friend or use my credit card.
Throughout life, we can expect these inconveniences because they are part of life. Your car and household appliances will need repairs and you will have to replace many items in your home — that’s fact. You may have to visit urgent care. Or, you may receive an unexpected and tax bill.
The easiest way to take care of these unforeseen and unwelcome expenses will be to have an emergency fund. And, in a way, an immediate annuity can be another type of emergency fund you can rely on throughout your retirement.
What is an Immediate Annuity and How Does it Work?
Let’s be clear here. Unlike an emergency fund, an immediate annuity can not be as easily accessed. However, as the name implies, you can begin receiving annuity payments immediately — within a month after you’ve purchased the contract. That makes it more beneficial than a deferred annuity if you’re already retired and want a guaranteed income to cover living expenses or medical costs.
I know. This might sound too good to be true. So, let’s break down immediate annuities.
Also known as a single premium immediate annuity (SPIA), this is an insurance product that guarantees a fixed retirement income. You pay a lump sum, aka premium, to an insurance agent/company, broker, or financial advisor and will receive regular payments.
Typically, immediate annuity payments will be distributed one month after its purchase — as opposed to a deferred annuity where your delay payments for a year or more. As the annuitant, you also can determine the frequency of payments. Referred to as the “mode,” you can receive payments monthly, quarterly, or even yearly.
Immediate payment annuities are often used to supplement other retirement sources like Social Security. It’s possible to buy an immediate annuity that will provide a steady income for life or a set period of time, such as 5 or 10 years.
The amount of these payments will vary based on factors like age, prevailing interest rates, and how long you want payments to contine. Generally, immediate annuities have a fixed interest rate, but only for the period of the contract. However, some insurers will offer immediate variable annuities. Similar to variable deferred annuities they fluctuate based on the performance of an underlying portfolio of securities. And, there’s also the inflation-protected annuity, or inflation-indexed annuity, which increases payments that are in line with future inflation.
Types of Immediate Annuities
As with most types of annuities, there’s no such thing as a one-size-fits-all immediate annuity. Often, the different types of immediate annuities are often determined by how they are classified. It’s important to have at least a basic understanding of these classifications so that you can select the right type that best aligns with your retirement plan.
The first thing to know is that annuities are categorized by the returns that they’ll provide. This will either be variable, fixed or index. However, annuities can further be classified on the length of the payments. Usually, annuity payments will either last for a lifetime or a specific amount of years.
We know. This can get confusing real fast. So, let’s dig deeper into each annuity classification.
Variable Immediate Annuities
Variable annuities, regardless if it’s deferred or immediate, have payout rates that vary based on market performance. As such, this makes them perform similarly to investment accounts like a 401(k) or IRA.
You purchase a variable annuity with a lump sum payment. Next, you select the subaccount you want to invest in. Subaccounts, like mutual funds, contain stocks, bonds and, money market funds. So, when your investments are crushing it, your annuity payout will increase. On the flip side, when your investments tank, your annuity payments will decrease.
In short, variable annuities do provide the potential for growth. These types of annuities are also tax-deferred and historically exceed inflation rates. However, it’s also possible to lose money and there’s also little protection against premature death.
With that in mind, a variable annuity should be considered if you can tolerate short-term changes. It also wouldn’t hurt to have a diverse portfolio to help soften the blow if the market takes a turn for the worse.
Fixed Immediate Annuities
This type of annuity works much like CDs. You make an upfront payment and in exchange, you’re promised a series of regular income. Fixed immediate annuities don’t involve the risk that variable annuities do since you’re not playing the market. As such, this creates a more stable and predictable annuity payment.
Of course, fixed annuities also have disadvantages. Mainly, your returns can be much lower than those from a variable annuity. Moreover, because you’re locking up your money into a fixed interest rate, that prevents you from investing in more fruitful investments. And, there’s the chance that inflation will diminish the value of your funds.
However, that’s the price you pay with a fixed annuity. Your returns might not be as much, but you’re protected against market volatility and you’ll have a reliable income.
Index Immediate Annuities
Also known as fixed index annuities, this type of annuity is kind of like a hybrid between a variable and fixed annuity. The reason is that your payments are linked to a market index, such as the S&P 500. As with variable annuities, when the index is performing well, you’re going to receive a larger payment. But, when the index drops, so does the size of your payments.
Also, caps and potential gains and losses come with an index immediate annuity. That means that there’s less volatility than with a variable annuity. That also means you aren’t going to earn as much throughout the good years. But, the bad years won’t sting as much.
Furthermore, immediate annuity losses usually have a floor. As such, you can rest assured knowing that the initial amount you used to invest in the index immediate annuity is safe and sound.
Term Immediate Annuities
Believe it not, some people don’t always need a lifetime income. However, they could use an income stream for the next five to 20 years to pay off excessive debt or medical bills. Maybe you’re just buying a little time until another income source kicks in, like a pension or Social Secruity.
If you’re in this situation, there’s something called a term immediate annuity. It’s similar to other annuity types in that you purchase the premium with a lump sum. In exchange, you’ll receive payments for a set period of time. This is called a term and can range however long you like — in most cases five to 20-years.
Once the term ends, so do the payments. And, if you’ve named a beneficiary and die during the time, those scheduled payments will be passed on to them.
In short, a term immediate annuity is meant for anyone who needs an income for a set period of time. And, they can also come in useful when funding a life insurance policy as this typically requires a fixed funding arraignment.
Lifetime Immediate Annuities
But, what if your heart is set on guaranteed lifetime payments? No worries. There’s also a lifetime immediate annuity.
As you’ve most likely guessed by the name, with this annuity you’ll receive lifetime payments after buying the contract. You also have the option to set up a joint lifetime annuity which would cover the lifespan of you and your spouse, as an example.
Just know that when it comes to joint lifetime annuities, lifetime payments will continue as long as at least one of you are still alive. Also, payments may be lower since this is covering two lifespans, which increases the probability of at least one of you living a long and precious life.
The main perk with a lifetime immediate annuity, whether joint or single, is that you’ll always have a source of retirement income.
The Advantages of Immediate Annuities
The biggest advantage with an immediate annuity? In the words of Boston, “All I want is to have my peace of mind.”
As with all annuity types, an immediate annuity can provide you with a safe and dependable income — sometimes for the remainder of your life. But, immediate annuities also come with additional perks, such as;
- You skip the accumulation phase. Unlike a deferred annuity, an immediate annuity doesn’t require an accumulation phase. As such, you can access your money within a month after purchasing the premium. That makes it ideal for anyone who needs money right now.
- Adds stability to your portfolio. As long as you have a balanced portfolio, an immediate annuity can help even out assets that fluctuate in value.
- Simplicity. Depending on the exact type of immediate annuity you’ve bought, you can pretty much set-it-and-forget-it. For example, if you purchased a fixed immediate annuity, you know exactly what you’ll be getting when you receive payments.
- Manage your tax burden. Annuities are tax-deferred meaning that you don’t have to pay taxes until withdrawals begin.
- Higher returns than those of safer investments like certificates of deposit or Treasury rates. But, you may not earn as much as riskier investments since your principal is protected.
- Not exposed to the market. Unless you choose a variable immediate annuity, your money is isolated from market volatility.
- No sales or administrative costs. Immediate annuities do not have annual account management or maintenance charges. As a result, 100% of your premium will be put towards your monthly income.
- Customizable. You decide on how much and how long you want to get paid. Moreover, you can set a “Single” or “Joint” annuity. And, thanks to riders, you can also protect yourself against inflation or attach a death benefit.
The Disadvantages of Deferred Annuities
Of course, immediate annuities aren’t flawless. Here are some of the criticisms regarding immediate annuities.
- High upfront cost. With an immediate annuity, you’re paying for the entire contract upfront with one payment. So, if you don’t have a substantial amount of money set aside, you might want to consider a deferred annuity that lets you make a series of smaller payments.
- Irrevocable. This can’t be stressed enough. Annuities aren’t liquid. Once the annuity is in full effect you have no say in how much and often you can get paid. So, if you have an emergency, you may not be able to tap into the annuity. Even if you can make a withdrawal, it may be only a percentage or you will have to pay surrender charges.
- Can lose value from inflation. If you have an immediate fixed annuity, inflation could decrease the value of your annuity. You could purchase a cost of living adjustment rider to address this concern.
- Payments can decrease or cease. The annuity benefit will stop when you pass away. You can add on a death benefit so that payments can be passed on to a beneficiary. But, they can expect lower returns.
Is an Immediate Annuity Right For You?
The ideal candidate for an immediate annuity is someone who is either retired or approaching retirement. It’s the perfect companion to Social Security as it provides a guaranteed income. But, more especially, an immediate annuity is designed for those who need money today rather than tomorrow.
If you’re still on the fence, you might want to meet with a financial advisor. Because they are required to undergo annuity training by their State Insurance Department, they can help you make a more informed decision about immediate annuities.
Immediate Annuity FAQs
How can you fund an immediate annuity?
If you decide to purchase an immediate annuity, you must do so using a lump sum. This lump sum, or premium, must be paid upfront and in full. The good news? You have plenty of options to fund an immediate annuity.
First, you can use non-qualified funding sources. These are items that you’ve already paid taxes on, including;
- Certificate of deposit (CD)
- Mutual fund proceeds
- Money market accounts
- Life insurance settlement
- After-tax savings
- Deferred compensation
- A deferred annuity that was funded with the sources above
You can also fund the annuity with qualified sources that you’ve yet to taxes on, such as;
- 401(k) plans
- Simplified Employee Pension (SEP) plans
- Corporate-sponsored defined contribution plans
- Section 403(b) tax-sheltered annuities
- Section 1035 annuity exchanges
- Annuities previously funded with the sources above
Your next question, understandably, will most likely be, “How much does an immediate annuity cost?” That varies depending on your age interest rates. What’s more, it’s not uncommon for the agent who sold you the immediate annuity to snag a 3% commission.
What’s the return rate/payout on an immediate annuity?
That depends on several factors such as the number of monthly payments the owner receives, age, gender, premium, and Single vs. Joint Life. With a fixed annuity option like Due, you will get a 3% guaranteed interest rate on your money. Seriously. No funny business.
What are the tax implications of immediate annuities?
This ultimately depends on the type of money you use to purchase the immediate annuity. As mentioned above, if you used a qualified source, like rolling over retirement money that had never been taxed from a 401(k) or IRA. If so, the monthly payment would be taxable as income.
If you used non-qualified sources of funding, then your payments will only be partly taxable. You don’t have to worry about the portion that represents a return of your original premium. However, you will have to pay taxes on the interest or gains you’ve received beyond that is taxable.
What if you live beyond your expected lifespan and have collected your full premium back? All the money you receive each month is considered as taxable income.
What happens to an immediate annuity when you die?
If you’ve added a rider that lets you name a beneficiary, like your spouse or heirs, they’ll inherit the annuity. If you didn’t do this then the account balance will be distributed to other annuity holders. This is within a pool of annuitants who have also contributed premiums to the insurance company’s general account.