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Planning for your retirement income should start years before you retire.
But many folks don’t, and when they finally start thinking about how they are going to replace their paycheck, retirement is imminent.
Additionally, some people have to retire early because of a layoff or illness.
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Fortunately, there’s a good solution for procrastinators: An immediate annuity. While not the right answer for everyone, it can be invaluable in closing an income shortfall.
It converts your money into a stream of income that can be guaranteed for your lifetime and, optionally, that of your spouse, too.
You can create your own private pension and can have monthly payments begin as soon as one month after policy issuance, but no later than one year.
Issued by a life insurance company, the time-tested product is also called a single-premium immediate annuity (SPIA) or an immediate income annuity.
High guaranteed income
You can get more income from an immediate annuity than from almost any other vehicle. That’s largely because each annuity payment includes both nontaxable return of principal and taxable interest.
This assumes the annuity is “nonqualified” — not within an IRA or 401(k). It’s a bit like the opposite of a mortgage, where you’re paying both principal and interest.
An immediate annuity can also work well in an IRA, too. However, all payments from a tax-qualified immediate annuity will count as taxable income, unless it’s in a Roth IRA.
You can fund an immediate annuity using almost any source:
- The proceeds from a maturing bank certificate of deposit (CD)
- A savings or money market account
- Selling stocks, bonds, real estate or mutual funds
- Transferring money from a retirement plan account like an IRA or 401(k)
You generally fund an immediate annuity all at once with a “lump sum” or “single premium.”
All annuities come with a mandated “free-look period,” typically 20 to 30 days, depending on the state of issue. During this period, you can change your mind and return the policy for a full refund.
After the expiration of the free-look period, you are locked into the annuity’s terms. In other words, you can’t cancel the policy midterm, surrendering it for a lump sum of remaining unused principal.
Tailored options
The most straightforward immediate annuity is the single-life variety. It pays only while the annuitant (the person designated to receive payments) is still alive.
This type offers the highest income because the insurance company doesn’t have to return any unused premium. The people who die earlier than average subsidize those who live longer than average.
If you’re not concerned with leaving anything to your heirs, this option may be best.
With a joint life immediate annuity, payments continue as long as either of the two annuitants is alive.
If one person dies, the survivor continues to receive income, which may be the same amount (100% joint survivor) or a reduced amount (such as 50% or 75%).
Because payments are guaranteed for two lives rather than one, the income amount is lower than that of a single-life annuity, all other factors being equal.
The “life with period certain” option means the annuity will pay throughout the annuitant’s life and also continue making payments to a beneficiary.
If you die before the end of the “period certain” (such as 15 years), your beneficiary will get payments for the remaining portion of the specified term (usually five to 20 years).
If you live past the period-certain term, payments will stop at your death.
An “installment refund” immediate annuity also protects your beneficiary.
Suppose you bought a lifetime annuity but passed away a few years later, before you received payments equivalent to the premium you paid. With this option, your beneficiary will continue receiving regular payments until the difference has been made up.
So, if you deposited $200,000 into an immediate annuity and received $50,000 in payments, your beneficiary would continue to receive $150,000 more in installments.
The “cash refund” option is similar, but the beneficiary would receive the amount due as a lump sum.
How much does one pay now?
Here are a couple of scenarios.
Maria, single and 65, deposits $250,000 into an immediate annuity. Since she has no children or others she needs to protect, she chooses a single-life nonqualified SPIA.
She’ll receive $1,590 per month, including $549 of taxable interest and $1,041 of nontaxable return of principal. If she lives to age 85, the payments will become fully taxable then.
Ted and Doris, a married couple, are both 70. They also place $250,000 in an SPIA. They choose a joint life annuity.
They’ll get $1,566 per month ($554 taxable, $1,012 tax-exempt) as long as one of them is alive. After 247 months, if either Ted or Doris is living, the payments will become fully taxable.
Lifetime income equals peace of mind
Because immediate annuities are typically guaranteed to pay the same level of income for the rest of your life, they offer protection against the worrying possibility that you’ll outlive your savings.
Income annuities are the opposite of life insurance: They protect buyers from the financial risk of living a very long life.
They’re a great option if you’re concerned about replacing your income during retirement and want to add certainty to your financial future. Research shows that people with an adequate guaranteed income in retirement are happier and less anxious.
You won’t get rich with an immediate annuity. They’re designed to reduce risk and stress with guaranteed lifetime income.
While you might make more money in the long term by investing in stocks, the two key words here are “might” and “long term.” If you can hold on to your stocks for many years, you’re very likely to get a good return.
However, when you’re older, your time frame grows shorter.
Furthermore, stocks are volatile. If you’re forced to sell equities to raise money for income when the market is down, especially for an extended period, your portfolio can take a big hit that it might not ever fully recover from.
It’s almost forgotten now, but during the decade ending in 2009, stocks fell by an average of about 1.0% a year.
Stocks can be exciting; an income annuity is boring and dependable. It’s that dependability that makes it an excellent instrument for retirement planning.
Another argument for annuities is that they let you be a bit more adventurous with the remainder of your savings. When you have your basic income needs covered by an annuity and Social Security, you can afford to put less money in bonds or CDs and take on a bit more risk with stocks because you’re not as reliant on them.
Inflation protection — but at a cost
Standard immediate annuities don’t protect against inflation. You can, however, choose an inflation-protection rider that will boost payments by a fixed percentage each year, typically 1% to 3%.
However, your initial payments will be significantly lower. At current rates, a 3% annual boost might reduce your starting payment by 20% to 30% compared to a level annuity.
For most people, this feature isn’t worth the cost, I believe.
However, if you’re in great health and are buying an annuity at a relatively young age, you might consider this option. You’ll get less now, but if you receive payments long enough, you can more than make up for the lower initial payments.
Immediate annuities aren’t right for everyone. If you don’t need the income soon, you should consider a deferred annuity that will give you greater tax deferral longer.
Interestingly, the immediate income annuity is the only type categorized as an immediate annuity.
All other types are considered deferred annuities. They include deferred income annuities, which work the same way but defer payment for more than a year. Other deferred annuities include CD-like fixed-rate annuities (multi-year guarantee annuities), variable annuities and fixed indexed annuities.
Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities. Ken is a nationally recognized annuity expert and widely published author. A free rate comparison service with interest rates from dozens of insurers is available at www.annuityadvantage.com or by calling (800) 239-0356. The firm also offers an income-annuity quoting service. There are no fees or charges for the firm’s services; 100% of the client’s money goes to work for them in their annuity.