An immediate annuity, also known as an income annuity, is a type of annuity that begins paying out right away. With an annuity, you enter into a contract with an insurance company. In exchange for your payments, the insurance company will send you disbursements for a predetermined term — sometimes for the rest of your life.
Immediate annuities are distinct from deferred annuities, which have an initial accumulation phase during which the pool of money grows, followed by a later payout phase. Both immediate and deferred annuities are good tools for funding your retirement, though they serve different purposes. A deferred annuity allows your money grow tax-deferred so you’ll have income at a future date, while an immediate annuity is useful if you need regular income right away.
What is an immediate annuity?
If you’re already in retirement or plan on retiring soon, an immediate annuity might make more sense than a deferred annuity because you may have an immediate need for steady income. If you live a long time, an immediate annuity could pay out more than it initially cost. On the other hand, the insurance company may keep the money that’s left in accounts when a contract-holder passes.
Here are some considerations to keep in mind to determine if immediate annuities are right for you:
- Payments: With an immediate annuity, you’ll receive payments on a regular schedule, such as monthly or annually. The first payment will begin with your next scheduled payment. Immediate annuities can have either a fixed payment period, such as 10 or 20 years, or your annuity could pay out for your lifetime, or your lifetime plus the lifetime of a beneficiary (such as a spouse).
- Interest: The principal balance in your annuity will grow at a predetermined rate (i.e., it’s a fixed annuity), based on underlying investments (a variable annuity) or based on the growth in an index, such as the S&P 500 (an indexed annuity). Your payments may either be fixed or they could go up and down depending on whether you buy a variable or indexed annuity.
- Costs: A variety of fees can impact the growth of your annuity and your payments. Costs may include administrative fees, underlying fund fees, commissions and mortality and expense risk fees. Additionally, you’ll pay extra for riders, which are different types of add-ons that you can purchase for your annuity. For example, a cost-of-living adjustment (COLA) rider will increase your payments to keep up with inflation. Compare annuities to one another, and to other retirement options, before signing a contract.
Qualified immediate annuity vs. non-qualified: What’s the difference?
Depending on how you pay for your immediate annuity, it could be classified as either qualified or non-qualified.
“Qualified annuities refers to when the source of the funds comes from a tax-deferred account,” said Ray Caucci, chairman and CEO of Vantis Life Insurance Company. In other words, if you have money in an IRA, 401(k) or another type of tax-advantaged retirement account, and then use the money to buy an annuity, the annuity is considered qualified.
By contrast, if you use after-tax dollars (i.e., you don’t receive a deduction from putting your money into an account) to purchase an annuity, then it will be a non-qualified annuity.
In other words, the main difference between qualified and non-qualified immediate annuities is the taxes on your payments.
Immediate annuity taxation issues
Unlike when you contribute to a tax-deferred retirement account, the premiums you pay when you purchase an annuity aren’t tax deductible. But the payments you receive can be taxable.
If you have a qualified annuity — meaning you bought the annuity with money that was inside a tax-advantaged account — then the entire annuity payment is fully taxable as income. Unlike with investment distributions, the principal and interest or gains portions of your annuity payments are taxed as ordinary income rather than capital gains. And, similarly to tax-advantaged accounts, you may need to pay a 10% penalty fee if you withdraw money before you are 59½ years old.
Taxation is a bit trickier with a non-qualified annuity. “The benefit is split between a return of the principal and interest,” Caucci said. The interest or gains portion is subject to ordinary income taxes, while the principal portion isn’t taxed (because you already paid taxes on the money before you bought the annuity.)
“That’s done through the means of an exclusion ratio that’s determined by the insurance company,” Caucci said. The ratio, which depends on your life expectancy, is often shared as a percentage and indicates how much of each payment is non-taxable income from the principal. If you live beyond your life expectancy, your remaining payments will become completely taxable.
Who should invest in immediate annuities?
Immediate annuities are generally best for those who are already in retirement, or who are about to retire, and are looking for a low-risk option to boost their income. Particularly if you’re worried about outliving your savings, an annuity with a lifetime payout could ease that concern.
“It could be a foundational income source that doesn’t change,” Caucci said. “You can decide how you want to distribute your other savings and investments, but you always have a foundation of the income.”
One of the downsides is that the guarantee also means you might have to keep your money locked up in the annuity. “People who want more control over their retirement income won’t be as enamored with an immediate annuity,” Caucci said.
Immediate annuity pros and cons
While an immediate annuity could offer a secure and steady source of income during retirement, it’s not the right fit for everyone. Here are some of the pros and cons to consider: