How Does a Lifetime Annuity Work? An Overview

A lifetime annuity is a financial product designed to provide a guaranteed income stream for the duration of an individual’s life. It transforms a lump sum or series of payments into regular disbursements, offering financial predictability throughout retirement. Its primary purpose is to ensure a consistent source of funds, preventing individuals from outliving their savings.

Defining a Lifetime Annuity

A lifetime annuity is a contractual agreement between an individual and an insurance company. The insurer commits to making regular payments to the individual, known as the annuitant, for their entire life. This arrangement shifts the risk of outliving assets from the individual to the insurer, providing financial security.

Unlike other financial products, an annuity’s core function is to generate steady income. It is a tool for income distribution during retirement, not primarily for building wealth. The guarantee of payments for life distinguishes it from typical investment accounts.

Funding and Accumulation

Purchasing a lifetime annuity involves two main funding methods. An individual can use a single premium payment, a one-time lump sum, to buy the contract. Alternatively, some annuities allow for flexible premiums, made over a period like monthly or annually. These contributions form the initial investment.

The timing of income payments differentiates immediate annuities from deferred annuities. With an immediate annuity, payments start within 12 months after funding, suitable for those seeking immediate income. In contrast, a deferred annuity involves an accumulation period where funds grow before income payments commence at a predetermined future date. During this phase, funds grow tax-deferred.

Income Generation and Payouts

The process of converting accumulated funds into guaranteed income payments is known as annuitization. Once annuitization occurs, the insurance company calculates each payment based on factors like the annuitant’s age, life expectancy, and total invested amount.

Prevailing interest rates also play a significant role in determining the payout amount. Higher interest rates can result in larger periodic payments. The specific payout option chosen further influences payment size and duration, as options meet various income and legacy planning goals.

Variations in Lifetime Annuities

Lifetime annuities can be structured with various payout options, each impacting income distribution.

Single Life Annuity

A Single Life Annuity provides payments for the life of one individual. Payments cease upon the annuitant’s death, with no further benefits paid to beneficiaries.

Joint and Survivor Annuity

A Joint and Survivor Annuity extends payments over the lives of two individuals, usually spouses. After the first annuitant’s death, payments continue to the survivor, often at a reduced amount, for the remainder of their life. This option provides continued income security for a surviving partner.

Period Certain Annuity

A Period Certain Annuity guarantees payments for a specified minimum number of years, such as 10 or 20 years, regardless of whether the annuitant lives that long. If the annuitant dies before the period expires, remaining payments go to a designated beneficiary. Should the annuitant live beyond the period certain, payments continue for their entire life.

Cash Refund Annuity

A Cash Refund Annuity ensures that if the annuitant dies before receiving total payments equal to their initial premium, the remaining balance is paid to a beneficiary. This refund can be in a lump sum or installments, providing principal protection.

Tax Considerations

The tax treatment of lifetime annuity payments depends on how the annuity was funded. Annuities offer tax-deferred growth, meaning earnings are not taxed until withdrawals begin. When payments commence, the income received is subject to taxation.

Non-qualified annuities, funded with after-tax money, treat a portion of each payment as a return of original principal. Only the earnings portion is subject to ordinary income tax. This taxable portion is determined using an exclusion ratio.

Conversely, qualified annuities are funded with pre-tax money, often through retirement accounts like 401(k)s or IRAs. Because contributions were not previously taxed, the entire amount of each payment from a qualified annuity is considered taxable income at ordinary rates. Withdrawals from either type of annuity before age 59½ may also be subject to an additional 10% federal tax penalty.