What Is a Pure Life Annuity and How Does It Work?

An annuity is a financial contract between an individual and a life insurance company. The individual pays a premium to the insurer. In return, the insurer provides regular payments to the annuitant, either immediately or at a future date. Annuities generate steady cash flow for retirement income planning and to address longevity risk.

Core Characteristics of a Pure Life Annuity

A pure life annuity, also known as a single life or straight life annuity, provides guaranteed income for the annuitant’s entire lifetime. It ensures regular disbursements as long as the annuitant is alive, offering financial protection against outliving one’s assets. Payments cease entirely upon the annuitant’s death. There is no residual value, death benefit, or provision for payments to beneficiaries. If the annuitant dies shortly after payments begin, the initial premium’s remaining value is retained by the insurance company.

Once the premium is paid and the annuity is annuitized, the decision is irrevocable. Funds are no longer accessible as a lump sum or for other financial needs, as control shifts to the insurer. This transfer of funds and risk safeguards the annuitant from market fluctuations and ensures a consistent income stream.

Pure life annuities offer higher periodic payments compared to other annuity types because payments end upon the annuitant’s death. This higher payout reflects the absence of survivor benefits or guaranteed payment periods. It makes pure life annuities attractive to individuals prioritizing maximizing lifetime income without dependents. The inherent trade-off is the forfeiture of any remaining principal or earnings to the insurer upon death. This differentiates it from other annuity options that might include features like a period certain guarantee or joint and survivor benefits, which would extend payments to a beneficiary but result in lower monthly income.

How Pure Life Annuity Payments are Determined

Several factors influence the periodic payment an annuitant receives. The total premium paid is a primary determinant; a larger investment translates to higher lifetime payments. Prevailing interest rates at purchase play a role, particularly for fixed annuities, as higher rates lead to larger payouts.

The annuitant’s age at annuitization is another factor. Older individuals receive higher payments due to shorter life expectancy, meaning the insurer expects fewer payments overall.

Actuaries use statistical modeling and life expectancy data to calculate pure life annuity payments. They rely on mortality tables, which provide average life expectancies based on demographics.

Gender influences payment calculations, as statistical life expectancies differ between men and women. This results in payout variations for same-aged individuals of different genders.

The insurance company calculates a payout rate based on these factors, aligning expected payments with the initial premium and projected lifespan. The payout rate is a percentage of the annuity’s balance the annuitant receives annually. This rate is fixed at contract time, dictating the consistent income stream.

Tax Implications of Pure Life Annuities

The income received from a pure life annuity has tax implications that depend on how the annuity was funded. For non-qualified annuities, purchased with after-tax money, only a portion of each payment is subject to taxation. This non-taxable portion represents a return of the original premium paid, on which taxes have already been settled.

The Internal Revenue Service (IRS) employs an “exclusion ratio” to determine the taxable and non-taxable parts of each payment from a non-qualified annuity. This ratio is calculated by dividing the investment in the contract (the total premium paid) by the expected return from the annuity, which is based on the annuitant’s life expectancy according to IRS actuarial tables. For example, if the exclusion ratio is 75%, then 75% of each payment is considered a tax-free return of principal, and the remaining 25% is taxable income.

Once the original investment has been recovered through these tax-free portions, all subsequent annuity payments become fully taxable as ordinary income. If an annuitant lives beyond their statistically projected life expectancy, the entire payment will be subject to taxation.

In contrast, annuities funded with pre-tax dollars, referred to as qualified annuities (e.g., those from an IRA or 401(k)), are fully taxable upon withdrawal. The entire payout is considered ordinary income because neither the contributions nor the earnings have been previously taxed. This distinction highlights that while all annuities offer tax-deferred growth, the tax treatment of the income stream during the payout phase varies significantly based on the funding source.