What Is an Immediate Annuity and How Does It Work?

An immediate annuity is a financial product designed to provide a steady stream of income, often utilized by individuals approaching or in retirement. It converts a lump sum of savings into regular, predictable payments. This arrangement can help ensure a consistent cash flow, supplementing other income sources like Social Security benefits or pensions. The core purpose of an immediate annuity is to offer financial stability by guaranteeing an income stream.

Defining Immediate Annuities

An immediate annuity is a contract between an individual and an insurance company. The individual provides a single, upfront payment, known as a premium, to the insurer. In exchange, the insurance company commits to making guaranteed income payments that typically begin within 30 days to one year. This conversion of a lump sum into periodic payments is called “annuitization.” The individual receiving payments is the “annuitant.” Unlike deferred annuities, which allow money to grow over time before payments begin, an immediate annuity is characterized by the near-instantaneous start of income distribution, making it suitable for those needing immediate cash flow from their savings.

How Immediate Annuities Work

An immediate annuity converts a single premium into ongoing income payments. Once the lump sum is paid to the insurer, that money generally becomes irrevocable, meaning it cannot be easily accessed again. The amount of the regular payments the annuitant receives is determined by several factors at the time of purchase. These factors include the annuitant’s age, with older individuals typically receiving higher payments due to a shorter life expectancy. Prevailing interest rates also play a role, as higher rates can lead to larger initial payouts. The payout option chosen by the annuitant further influences the payment amount and duration. The payments can be set to occur monthly, quarterly, or annually.

Variations and Payout Options

Immediate annuities offer various payout structures, primarily focusing on fixed payments for predictability.

• Single Life Annuity: Provides guaranteed income for the annuitant’s entire life. Payments cease upon the annuitant’s death, and no further benefits are paid to beneficiaries unless riders are added.
• Joint Life Annuity: Ensures payments continue for the lives of two people, often a spouse. The income amount for a joint life annuity is generally lower than a single life option because the payments are expected to last for a longer combined duration.
• Period Certain Annuity: Guarantees payments for a specific number of years, regardless of the annuitant’s longevity. If the annuitant dies before the period ends, a named beneficiary receives the remaining payments.
• Life with Period Certain: Combines these features, providing income for the annuitant’s life but guaranteeing payments for a minimum specified period. If the annuitant passes away before this guaranteed period concludes, beneficiaries receive payments for the remainder of that term.

Taxation of Immediate Annuities

The income received from an immediate annuity is subject to tax rules, which depend on whether the annuity was purchased with pre-tax or after-tax funds. For annuities funded with after-tax money, each payment is partly a return of the original principal and partly taxable earnings. The return of principal portion is not taxed again, as taxes were already paid on those funds. The Internal Revenue Service (IRS) uses an “exclusion ratio” to determine the non-taxable portion of each payment. This ratio is calculated by dividing the investment in the contract by the total expected return over the annuity’s payout period. Once the total amount of the original principal has been returned through these payments, any subsequent payments become fully taxable as ordinary income. If the annuity was funded with pre-tax dollars, such as from a traditional IRA or 401(k) rollover, then the entire amount of each payment is taxed as ordinary income.

Key Factors Before Purchasing

An immediate annuity requires evaluating several factors to ensure it aligns with individual financial objectives. The product serves individuals seeking a predictable cash flow, particularly those in or nearing retirement who desire a guaranteed income stream to cover essential expenses. It can provide protection against the risk of outliving one’s savings, often referred to as longevity risk, by guaranteeing payments for life. However, it is important to acknowledge the irrevocability and limited liquidity associated with immediate annuities. Once the lump sum is converted, it is generally not accessible for unexpected financial emergencies. The prevailing interest rate at the time of purchase also influences the initial payout amount, as lower rates can result in smaller payments. Additionally, while payments are typically fixed, this can mean that their purchasing power may diminish over time due to inflation, unless an inflation-adjusted payout option is selected, which often results in lower initial payments.