Saturday, November 23, 2024
Regardless of whatever other categories into which they may fall, all annuities share one defining characteristic: they provide for an optional guaranteed lifetime income, an income you cannot outlive. Activating this lifetime income is called annuitization.
Annuitization is the process of converting a lump sum into a guaranteed income. Typically, this income is guaranteed for the lifetime of the annuitant and often their spouse but can be for a period of years, such as ten or twenty. The key is the income is guaranteed and not dependent on any external factors such as interest rates or the level of the stock market. The income available from a lump sum is set when the annuity is annuitized and, unless called for in the contract between you and the annuity company, will never change.
Annuitization insures against the risk of living too long and outliving your money. If you live longer than your life expectancy, you win, and the annuity company will lose. If you die before your expected life expectancy, the annuity company will win, and you won’t be around to suffer the loss! Either way, the risk you faced of living too long and the problem of needing to properly allocate your assets to make sure you never run out of money has been transferred to the annuity carrier. The carrier knows that the average person will live to their average life expectancy given the thousands of annuities they sell. This is an example of the Law of Large Numbers.
The standard annuitized payment is on the life of one person, with payments continuing for that person’s entire life and ceasing at their death. The amount of that payment is based on their age at the time the annuitized payments begin.
But some optional payout plans can vary how long payments continue and the amount you will receive. In our examples of the types of annuitized payments, we will assume that the annuitant (the person who will receive the annuity payments and on whose life they are based) is a 65-year-old male with a 65-year-old female spouse. We will also assume they have $100,000 to invest in the annuity. Keep in mind these examples are approximations. Each annuity carrier sets its own rates, and, as in all things, it pays to shop around.
A single-life annuity. Sometimes referred to as a “straight-life annuity,” is just what it says: a series of guaranteed payments based upon the life of one person and no other factors. A 65-year-old male who invested $100,000 into an immediate annuity would receive guaranteed payments of around $561 per month. Those payments are guaranteed and will be paid every month until his death, when they will cease.
A single-life annuity can be modified by adding an optional “period certain.” Period certain means that if the annuitant dies before the end of that period, payments will continue to his beneficiary for the remainder of that period. For example, a single-life annuity with a ten-year period certain would make payments for a minimum of ten years. If the annuitant lives ten years, payments would stop at his death. If, however, he died after eight years, the annuity payments would continue to his beneficiary for two additional years.
Single life annuities are available in a range of periods certain, but the most common are ten and twenty years. A 65-year-old male who invested $100,000 into an immediate annuity with a ten-year period certain would receive payments of around $550. Twenty years, $541.
As you can see, the payouts for the annuities with the period certain are lower. That is because the risk is shifted back toward the insurance company and is lowered for the annuitant.
A single-life annuity may have a cash refund option. In this case, instead of having a period certain, the annuity will payout at least until the annuitant has received payments that total the amount of his investment, in this case, $100,000. If the annuitant dies before receiving $100,000, payments will continue until all payments to the annuitant and his beneficiary together total $100,000. A 65-year-old male who invested $100,000 into an immediate annuity with a cash refund option would receive payments of about $517.
An immediate annuity can be based on the lives of two people, usually spouses. A joint-life annuity will continue to make payments until the second spouse has died. In some cases, the annuity will pay the survivor 50%, or some other percentage, of the original amount. This might make sense in some cases because the cost of living for one person is typically lower than for two. Also, the survivor might have access to assets available only upon the death of the first spouse, such as the death benefit from a life insurance policy.
The ages of the two spouses will affect the annuity payment. A couple with one spouse who is much younger will receive less than an older couple. In our example, we will assume both spouses are age 65 and that equal payments will continue to the surviving spouse.
A 65-year-old male with a 65-year-old female spouse who invests $100,000 into an immediate joint-life annuity with no period certain will receive monthly payments of about $483. With a ten-year period certain, about the same. With a 20-year period certain, $479. A cash refund joint annuity would pay them about $476.
Protection from inflation is something annuity purchasers, or anyone on a fixed income can worry about. It is possible to add a COLA rider to your annuity. But like anything that reduces the risk, it will reduce the annuity payment.
The taxation of annuitized payments can be confusing. If you are considering an immediate annuity, you should understand all of the tax considerations and how they will impact your situation. You may want to consult with a tax professional for advice specific to you.
If the source of the funds for your immediate annuity is an IRA, 401(k), or some other pre-tax retirement account, you will be taxed, as ordinary income, on every dollar your annuity pays you. The funds inside a retirement account have not yet been taxed. They are taxed when they are withdrawn, and an annuity payment is a withdrawal for tax purposes.
If your immediate annuity was or will be, purchased with “after-tax” funds, such as from a savings account, the taxation is a bit more complicated.
Each annuity payment, until your life expectancy, will be subject to an “exclusion ratio.” That is, part of each payment will be excluded from taxation. You will receive it tax-free. While the precise amount that is excluded can vary and will be provided to you by the annuity carrier, your age, the age of any joint annuitant, and the length of a period certain option, if any, all impact the amount of the exclusion ratio.
The exclusion ratio can be estimated, though. For example, if the amount you plan to invest into your immediate annuity is $100,000 and if your life expectancy is 20 years, according to the IRS tables, then you would receive the first $5,000 every year or about $417 per month excluded from taxation. That means that about 80% of the payments would be tax-free.
In the 21st year, and all subsequent years, the annuity payments would be fully taxable.
The net effect of the way annuities are taxed is that the bulk of the tax burden is deferred until after your life expectancy. Contrast this with the way a savings account is taxed. If your $100,000 bank account earns 5% interest each year and if you make withdrawals of $561 per month, $417 of each monthly payment will be taxed. Only $144 will be excluded from taxation. And keep in mind, the annuity guarantees an income you cannot outlive.
The exclusion ratio is one of the major benefits of using immediate annuities to fund all or part of your retirement income.
As we said elsewhere, advisors are well compensated by annuity carriers for marketing and selling their products. More problematic, is that those commissions are not disclosed making objective comparisons between various offerings difficult, if not impossible. However, in our experience, while commissions can vary from carrier to carrier and from annuity type to annuity type, they do not vary between the various types of immediate annuities. That is, while an advisor will receive a commission when you purchase an immediate annuity, that commission will not change regardless of your choice between, for example, a Single Life Annuity or a Joint Life Annuity with a Ten Year Period Certain.
