What Is an Immediate Annuity?

November 14, 2023

What Is an Immediate Annuity?

November 14, 2023

Share this post:

Company-provided pensions are on the way out, but what if there was a way you could purchase your own “pension” of sorts?

What Is an Immediate Annuity?

Annuities, in general, are purchased as an income guarantee to supplement other retirement income, like Social Security and 401(k)s. They reduce the risk of outliving your retirement savings, turning a portion of your assets into a paycheck that continues for your lifetime. They are an insurance product, not an investment product. An immediate annuity is an insurance contract between the purchaser, or annuitant, and an insurance company. These types of annuities are often called SPIAs, or single-premium immediate annuities. The insurer pays the annuitant a guaranteed income almost immediately after the annuity is funded (or within one year maximum); this is the main difference between an immediate annuity and a deferred annuity, which begins paying the annuitant at a later specified time. You can read more about annuities in general here.

Payment amounts are generally fixed over the contract’s term, but annuities with variable and inflation-adjusted payments are also available. Variable annuities fluctuate based on the portfolio performance; inflation-protected annuities, called cost of living adjustment or COLA riders, come with the promise of increasing payments in alignment with inflation. Buyers can choose the frequency of payments (also known as the “mode”)—either monthly, quarterly, or annually. Annuity payments are calculated based on your personal characteristics (age, gender) and the options you select for your annuity (premium, single vs. joint life, payout options, inflation protection, and other available benefits).

Immediate annuities are typically purchased with a lump sum payment, after which the insurance company begins paying the annuitant a regular income. While it’s more common that annuitants purchase SPIAs that guarantee lifetime payments, annuities are available with shorter-term contracts that may pay for a more limited time period (e.g., 5 or 10 years). Immediate annuity payments end upon the death of the annuitant. Herein lies the risk in annuities: Annuitants who die prematurely will generally not recoup their initial principal or any resulting gains while those who live longer lives (beyond their initial principal investment) come out ahead. One strategy to circumvent this problem is to purchase the annuity with a second person, referred to as a joint and survivor annuity. You can also customize your annuity to meet your specific circumstances and address your concerns by adding riders for an additional cost—some may guarantee payments to survivors/beneficiaries for a specific amount of time while others may refund the remaining portion of the principal if the annuitant dies prematurely. Again, these cost extra—and sometimes a lot extra—so keep that in mind when considering this type of annuity.

How Are Immediate Annuities Funded and Taxed?

There are two methods for funding an immediate annuity depending on the source of the funds you used to purchase it.

Qualified immediate annuities are purchased with tax-sheltered or untaxed money, which means that the entire annuity payment will be taxable as income using the standard income tax rates. These funds could have come from tax-deferred 401(k) or other employer-sponsored retirement plans or other tax-deferred retirement arrangements or annuities.

Non-qualified immediate annuities are purchased with money for which taxes have already been paid. A portion of each annuity payment is considered a return of the previously-taxed principal and would not be taxed further. This is calculated by the annuity issuer using an exclusion ratio. The remaining payment portion for which taxes have not been paid would be taxed as income. Once the initial premium has been fully returned, all remaining payments consist of interest earnings and are fully taxable. These funds may come from after-tax savings or retirement accounts, proceeds from the sale of real estate, a business, or other investments, and/or an inheritance among other things.

Annuities can be purchased through insurance agents, brokers, and financial advisors. You may be able to shop online for some annuities as well.

Types of Immediate Annuities

Fixed immediate annuities guarantee a—you guessed it—fixed payment. These are relatively low risk as they are independent of market performance—but with lower returns as a result.

Variable immediate annuities operate similarly to retirement investment accounts like 401(k)s and IRAs as they rise and fall with the markets, often with a minimum guaranteed amount with the rest tied to stock market performance. Your principal is placed into subaccounts that work in a similar fashion to mutual funds—the insurance company invest in groups of assets. If your investments perform well, your payment goes up. If they don’t, your payments may go down. The risk with this type of immediate annuity is that you might lose money in the short term. A variable immediate annuity might be right for someone with a higher risk tolerance who can stomach some fluctuation in returns in exchange for greater growth potential over the long term. These types of annuities also keep up better with inflation, as market returns historically outperform inflation rates.

Index immediate annuities are tied to a market index but generally cap your gains and losses to balance volatility in your annuity payments. You’ll earn less in good market conditions but make more when the markets are underperforming or down. They also have a “floor,” meaning you won’t lose your principal no matter what is happening in the market.

Term immediate annuities have a set timeframe for annuity payments, meaning you don’t necessarily have the guarantee of lifetime income if you outlive your contract term. Lifetime immediate annuities are contracted to pay out for your entire life or the life of the surviving annuitant if you purchase a joint annuity.

Advantages & Disadvantages of a SPIA

Security – An annuity is guaranteed lifetime income. You can’t outlive it—unless your annuity contract ends at a certain time period. Having a guaranteed income stream may mean you can take more risk—with the opportunity for greater returns—with some of your other investment vehicles.

Simplicity – An immediate annuity has very little upkeep; it’s often a one-time purchase with little intervention needed from you throughout its lifespan. Adding one to your portfolio can dramatically simplify a portion of your retirement planning. An immediate annuity is also a simple product compared to other types of annuities.

Customizable – You can purchase additional features, or riders, to add benefits to your annuity contract. You can also pick how often and how long you will receive payments.

Principal protection – Your principal is protected from market swings.

Higher returns than CDs or Treasury rates – Insurance companies generally use higher interest rates to calculate annuity payments than CD or Treasury rates.

High upfront cost – Since you’re funding this type of annuity in full at one time, you’ll need a considerable amount saved up—and all of this money will exit your bank account at the same time.

Mostly illiquid – Annuities are generally illiquid products, meaning you can’t quickly convert it to cash if needed. However, some annuity providers and products offer some level of liquidity in the form of commutation, which permits you to accelerate the withdrawal upcoming payments for a limited period of time. However, because payments begin immediately, you no longer have control over your deposit. In the case of an emergency, it may be expensive to break the contract to access the funds. It’s important to consider this in your planning: Do you have a rainy-day fund to account for emergencies? Or is your annuity premium part or all of your emergency fund?

No cash value – Annuities do not have a cash value that can be withdrawn in total or borrowed from.

Reduced purchasing power – If your payments lose value from inflation, this could eventually end up decreasing your purchasing power of your annuity income. Variable, inflation-protected, or fixed index annuities can address this issue.

No market exposure – Your principal and the income you’ll receive is protected from market exposure and volatility (unless you purchase a variable immediate annuity). This can be a great feature for those looking to seek some safety in their portfolio but isn’t right for those seeking investment returns.

Who May an Immediate Annuity Be Right For?

  • Do you want to build some security in your portfolio with protection against market volatility? Do you have a large gap between your expected retirement expenses and your retirement income sources, like Social Security?
  • Are you healthy?
  • Are you concerned about outliving your retirement savings?
  • Do you need money for your retirement right now—or very soon in the future?

If you answered yes to any of these, an immediate annuity might be right for you.

An annuity—period—isn’t right for everyone. If you have saved millions of dollars for your retirement and/or have significant amounts of liquid assets, an annuity may not be necessary—or suitable—for you. If you don’t need income right away, it may be better to use another investment vehicle or explore deferred annuities instead.

A diversified portfolio is incredibly important to retirement success and financial security, and an annuity could be a piece of that puzzle. It is inadvisable to invest all of your resources into a single annuity contract—maintain some of your retirement assets in other types of accounts and have available cash on hand for other expenses and emergencies. Make sure you work with a reputable company to purchase your annuity, as they are backed by the financial strength of the insurer, not the FDIC, any federal agency, or a bank. For more information and expert guidance on purchasing the right annuity for you and your needs, consider working with a financial advisor who can help you wade through all your options—and all the technical jargon and complexities of annuities.

Every strategy is dependent on a variety of different factors, so make sure you read the fine print.

If you want to learn about more personalized and advanced strategies, click HERE to schedule a 15-min call with our team.

Click here to attend a future Liberty Group LLC webinar.

Want expert retirement and investing advice? Subscribe to our YouTube channel and check out our weekly podcast with The Sandman!

Listen to Protect Your Assets anywhere you get your podcasts:

Standard Disclosure

This blog expresses the author’s views as of the date indicated, are subject to change without notice, and may not be updated.  The information contained within is believed to be from reliable sources.  However, its accurateness, completeness, and the opinions based thereon by the author are not guaranteed – no responsibility is assumed for omissions or errors.  This blog aims to expose you to ideas and financial vehicles that may help you work towards your financial goals. No promises or guarantees are made that you will accomplish such goals. Past performance is no guarantee of future results, and any expected returns or hypothetical projections may not reflect actual future performance or outcomes. All investments involve risk and may lose money. Nothing in this document should be construed as investment, tax, financial, accounting, or legal advice. Each prospective investor must evaluate and investigate any investments considered or any investment strategies or recommendations described herein (including the risks and merits thereof), seek professional advice for their particular circumstances, and inform themselves about the tax or other consequences of any investments or services considered.  Investment advisory services are offered through Liberty Wealth Management, LLC (“LWM”), DBA Liberty Group, an SEC-registered investment adviser.  For additional information on LWM or its investment professionals, please visit www.adviserinfo.sec.gov  or contact us directly at 411 30th Street, 2nd Floor, Oakland, CA  94609, T: 510-658-1880, F: 510-658-1886,  www.libertygroupllc.com. Registration with the U.S. Securities and Exchange Commission or any state securities authority does not imply a certain level of skill or training.