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An income annuity provides a guaranteed lifetime income stream that you purchase from an insurance company to help ensure you don’t outlive your income. Purchasing an income annuity is not the same as purchasing other investments; rather, it is insurance you purchase to mitigate longevity risk. This is because when you purchase an income annuity you convert a portion of your retirement nest egg into a guaranteed lifetime paycheck that you can not outlive.
An income annuity can be funded in many different ways – with qualified money from an Individual Retirement Account (IRA) or from your personal non-qualified savings (money you’ve already paid taxes on.
Income annuities can be customized to meet your goals, but they all provide the same thing – a guaranteed, steady, lifetime-income stream in retirement. Using an income annuity to generate a guaranteed minimum income floor can simplify your retirement spending and provide peace of mind.
Annuity income comes in many different types, most of which we’ll cover in this guide. My Annuity Store offers single premium immediate annuities (SPIAs), deferred immediate annuities (DIAs), Qualified Longevity Annuity Contracts (QLACs) as well as fixed index annuities with an income rider. All of which can provide guaranteed lifetime annuity income.
|Types||Single Premium Immediate Annuity (SPIA)||Deferred Immediate Annuity (DIA)||Qualified Longevity Annuity Contract (QLAC)|
|Starts||Within 12 Months||In more than 12 months||In more than 12 months, after age 72, and by 85|
|Provides||Guaranteed income for the rest of your life,|
or for a certain period
|Guaranteed income for the rest of your life,|
or for a certain period
|Guaranteed income for the rest of your life|
|Funded With||Qualified (IRA) or non-qualified||Qualified (IRA) or non-qualified||Only qualified money (IRAs)
Longevity risk, the risk of outliving your money in retirement, is arguably the greatest of the 5 Major Risks everyone will face in retirement. This is because longevity risks amplify all other risks. The longer you live the more opportunity to be impacted by market volatility, inflation or interest rate risk, and major healthcare costs.
Income annuities transfer this risk to the issuing insurance company and reduce the chance of outliving your money. In essence, it is society pooling together its resources for the greater good over everyone. Those who live longer gain benefit from others who do not live to, or beyond life expectancy.
The older you are the higher your life expectancy becomes.
Single Premium Immediate Annuities are considered to be the oldest form of an annuity, with the earliest recorded uses dating back thousands of years. Immediate annuities are also very straightforward making them easy to compare and shop for.
The purchase of a Single Premium Immediate Annuity (SPIA) is usually an irrevocable decision that cannot be undone once the free-look period has expired following the contract issue. However, within recent years many insurance companies have added a commutation benefit to their income annuities.
This commutation benefit allows you to withdraw a lump sum of up to 90% of your remaining payments’ present value.
When you purchase an immediate annuity you are simply purchasing a monthly paycheck that you will begin to receive within 12 months.
Payments can be guaranteed for a period certain, a specified number of years (usually 5 or 10 Years. Lifetime and joint-life immediate annuity options are also available.
|Income Annuity Payout Option||Annual Income Payout|
|10-year period certain||$9,805.32
|Life only - Male age 65||$5,354.64|
|Life with 10-year certain||$5,231.64|
|Life with 20-year certain||$4,808.88|
Rates are for Lincoln Insured Income Immediate Annuity as of 8/15/2020
A deferred immediate annuity also referred to as a DIA or longevity annuity, is an income annuity that pays guaranteed income payments that will not begin to be paid for as least 12 months after issue.
There are only 2 basic types of annuities: immediate annuities and deferred annuities. If you are approaching retirement and would like to purchase a guaranteed income stream then a deferred immediate annuity is also the most efficient way to do so.
Up until very recently, deferred income annuities were the least expensive way to purchase a future income stream. However, fixed index annuities with an optional “Income Rider” attached have been generating superior income payments vs Income Annuities.
Shopping for the best income annuity is honestly very close to shopping for a commodity. We use a third party service that gives us access to run live income annuity quotes from more than 30 insurance companies.
These types of income annuities are often referred to as a QLAC for short. QLAC’s are a special type of income annuity allowing that can be purchased with tax-deferred savings from your qualified retirement accounts, such as Traditional IRA or 401(k).
QLAC’s provide lifetime income that begins more than 1 year from purchase and between the ages of 701/2 and 85. Purchasing a QLAC is the only way to defer Required Minimum Distributions (RMDs) applicable to qualified funds such as 401(k)s and Traditional IRAs beyond the age of 701/2.
Update: President Trump signed The Secure Act in December 2019. You can read all revisions made to the IRS code by clicking here: H.R.1994 – Setting Every Community Up for Retirement Enhancement Act of 2019.
(Sec. 114) The bill increases from 70-1/2 to 72 the age for mandatory distributions from retirement plans.
(Sec. 107) The prohibition on contributions to a Traditional Individual Retirement Account (IRA) by an individual who has reached age 70-1/2 is repealed.
(Sec. 203) The bill requires benefit statements provided to defined contribution plan participants to include a lifetime income disclosure at least once during any 12-month period.
In July 201(Sec. 107) The prohibition on contributions to a Traditional Individual Retirement Account (IRA) by an individual who has reached age 70-1/2 is repealed.4, the U.S. Treasury Department removed a significant impediment to the ability of plan participants and IRA owners to balance their use of annuities and other investments in their retirement savings accounts. Ultimately, they issued final regulations that generally allow those individuals to bypass required minimum distribution (RMD) rules, which normally begin at age 70 1/2, for a portion of their total retirement savings.
As of 2020, over their lifetime, individuals cannot allocate more than $135,000 of their qualifying retirement plan (401(k), 403(b), 457(b), and Traditional IRA) savings to a QLAC.
Income will be higher for single life than joint life policies. A joint life policy will provide income as long as either person is alive. So in exchange for a smaller paycheck, you are able to “insure two lives” against longevity risk, the risk of outliving your assets.
The income level following the loss of the first life can be designed to remain level or decrease. Opting to reduce the income upon the passing of the first spouse (typically to 40-99% of the starting income level) allows for a greater income level while both are alive.
For example, a Joint Life and 50% Survivor-ship would reduce payments to 50% of the original amount upon the death of either of the owners. However, the reduced payments would continue for as long as one of the individuals is alive.
Payments stop at the death of the owner, even if death were to occur after only two monthly payments.
Additional guarantee that can be added to a life-only annuity. This option guarantees the full amount of your purchase premium will be paid back – whether it is to you or your elected beneficiary.
Example: You purchase a life with cash refund income annuity for $100,000 at age 65. Let’s assume your monthly income from this annuity is $550 and you live until the age of 75.
During your life, you would have received $66,000 ($550 x 12 months x 10 years ). Your beneficiary would receive a lump-sum payment of $44,000 (original $100,000 – $66,000 cumulative payments received).
Payments are guaranteed for the lifetime of the owner and a set number of years. Life with 20 year period certain is a common example. If you purchased a life with 20 year period certain at age 55 your income payments are guaranteed to continue to your age 75.
Should the owner pass prior to age 75 the payments would continue to be made to the elected beneficiary until the 20 years have passed.
Annuity payments are paid for a set period (typically 10 or 20 years) of time after which they will end. The rate of return on an income annuity with this payout option is not anything to write home about. These annuities are used as a tool and are not an investment.
Most often we use a 10 year period certain SPIA to fund a 10 pay permanent life insurance policy; sort of a life/ annuity arbitrage. Or, as an income bridge between retirement and full retirement age. During this “gap” you are in a low tax bracket due to the taxation of income annuities. We often will use this opportunity to “bracket-bump” and convert as much IRA money to a Roth as we can without hitting the next tax bracket up.
Period Certain SPIA’s can also be used in specific circumstances to help someone qualify for Medicaid by adding Irrevocable, Nonassignable, and Non-Transferable restrictions.
Income Annuities are sold by many different types of licensed agents, including:
The below chart shows what percent of annuity sales are made by the different types of financial professionals. The 2018 Year in Review, LIMRA, 2019.
An income annuity’s taxation depends first on whether the annuity was purchased with pre-tax (qualified) or post-tax (non-qualified) money. If the premium was paid with post-tax money, as with a non-qualified annuity, the portion of any income payments that constitutes a return of that premium will not be taxable. On the other hand, qualified annuities are purchased with pre-tax retirement savings. Because the money used to fund the annuity has never been taxed, all distributions from the annuity will be fully taxable. In either case, ordinary income tax rates will apply.
For immediate annuities with death benefit riders, a benefit would be due to a beneficiary if the cumulative income payments made are less than the initial premium paid. Any death benefit owed will be paid directly to the beneficiary, thereby avoiding the probate process. The annuity contract will typically be included in the deceased’s estate, and the beneficiary will be taxed on any proceeds they receive at ordinary income tax rates. Note that designating your spouse as your beneficiary will typically result in the annuity being excluded from your estate.
Because a non-qualified immediate annuity is purchased with after-tax money, your income payments will not be 100% taxable. Each income payment can be split into two pieces: a part that’s returning your initial investment, and a part that’s your gain or interest earned. Taxes will only be owed on the gain, as the premium you invested in the contract has already been taxed. This non-taxable portion of the income payment is determined using an exclusion ratio, which is provided by the insurance company at purchase.
Exclusion Ratio = Investment in The Contract ÷ Expected Return
The exclusion ratio will be applied to each income payment, indicating how much is not taxable, until the full investment in the contract has been paid out. Once the investment has been fully returned, subsequent income payments will be fully taxable.
Finally, if a death benefit is due to your beneficiaries, taxes owed will be calculated in a similar manner. Any portion of the death benefit that constitutes a return of premium will be received tax-free, whereas benefits in excess of the initial investment will be taxed at ordinary income levels. Either way, the benefit will be passed directly to beneficiaries, thus avoiding the probate process. And, unless your spouse is designated as your beneficiary, the annuity will typically be included in your estate.
Tax treatment of these payments can be tricky, so be sure to reach out to a tax advisor for a complete explanation.
What is a split annuity? A split-annuity is not a single annuity product. A split-annuity is a concept or strategy. The term split-annuity refers to purchasing two annuity products. You are “splitting” your money between two separate annuities.
A portion of your money is used to purchase an income annuity and the remainder is used to purchase a fixed annuity. There are different ways to do this.
A 10-year period certain single premium immediate annuity is usually the income annuity used in a split funded annuity. The fixed annuity is often a 10-year multi-year guarantee annuity (MYGA). Sometimes a fixed indexed annuity is used instead of a multi-year guarantee but since the rate of return isn’t guaranteed it is most common to see an MYGA used.
One way a split annuity is commonly used is to put an amount in the fixed annuity required to grow back to the original amount.
Example: You have $200,000 and purchase a 10-year fixed annuity for $150,000. At a 3% interest rate, your $150,000 would grow to approximately $202,000 in 10 years. Using the split annuity concept you use your remaining $50,000 to purchase a single premium immediate annuity.
The income annuity would generate approximately $460 of income for you per month for 10 years. At the end of the 10 year period, your $460.00 monthly paychecks would cease, but by that time your fixed annuity will have grown to $200,000 (the same amount you started with).
In summary, a split annuity concept is most often used by someone who would like to generate as much income as possible without touching their principal.
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