What Is an Immediate Annuity and How Does It Work?

An immediate annuity is a financial contract that converts a lump sum into a stream of regular, guaranteed income payments. Individuals nearing or in retirement often consider it to establish a predictable income source. It provides financial security, helping funds last throughout a person’s lifetime. This “paycheck-like” income can supplement other retirement funds such as Social Security or pensions.

Defining Immediate Annuities

An immediate annuity, also known as a Single Premium Immediate Annuity (SPIA), is a contract between an individual and an insurance company. The individual provides a single lump sum payment, and the insurer delivers regular income payments soon after purchase. These payments typically begin within one month to one year. A defining characteristic is that the payment amount is fixed at purchase, meaning the income stream does not fluctuate with market conditions. The individual receiving payments is the annuitant. This arrangement transfers the risk of outliving savings to the insurance company. The process of converting the lump sum into income payments is called annuitization. Immediate annuities differ from deferred annuities, which postpone payments, by providing income without a significant waiting period.

Mechanics of Immediate Annuity Payments

An immediate annuity operates on a single premium payment. This one-time lump sum funds all subsequent income distributions, distinguishing SPIAs from other annuities allowing multiple contributions. Several factors determine the payment amount. A larger initial lump sum generally results in higher periodic payments. The annuitant’s age and gender also play a significant role; older individuals often receive higher payments due to shorter life expectancies. Men may receive slightly higher payments than women of the same age due to average life expectancy differences. Prevailing interest rates at purchase also influence the payout; higher rates can lead to more generous payments. Payments can be scheduled monthly, quarterly, or annually. Once payments begin, the original lump sum is converted into an income stream, limiting direct access to the principal.

Customizing Your Payouts

Immediate annuities offer various payout options to tailor the income stream to individual needs. Each option influences the periodic payment amount, balancing higher payments against guarantees for beneficiaries or longer durations.

Life-Only Annuity

This option provides guaranteed income payments for the annuitant’s entire lifetime. Payments cease upon the annuitant’s death, and no funds pass to beneficiaries. It generally offers the highest individual payment amounts.

Period Certain Annuity

A period certain annuity guarantees payments for a predetermined number of years, such as 5, 10, or 20 years. If the annuitant dies before this period concludes, the remaining payments continue to a named beneficiary. This option balances guaranteed income for the annuitant with a financial provision for heirs.

Life with Period Certain Annuity

This hybrid option provides payments for the annuitant’s lifetime, but also guarantees payments for a minimum number of years. If the annuitant dies before the guaranteed period ends, payments continue to a beneficiary until that period concludes. If the annuitant lives beyond the guaranteed period, payments continue for their entire life.

Joint and Survivor Annuity

For couples, a joint and survivor annuity ensures payments continue for the lives of two individuals, typically spouses. Payments continue as long as either annuitant is alive, providing financial security for the surviving partner. The initial payment amount is usually lower than a life-only option, as it covers two lives, but various percentages (e.g., 50%, 75%, 100%) can be chosen for the survivor’s benefit.

Cash Refund or Installment Refund Annuity

This option addresses concerns about dying before receiving payments equal to the original premium. If the annuitant passes away before receiving payments totaling the initial investment, the remaining balance is paid to a beneficiary, either as a lump sum (cash refund) or in installments (installment refund). This ensures the initial principal is not entirely lost.

Optional riders, such as a Cost of Living Adjustment (COLA), can also be added. A COLA rider provides for annual increases in payments, typically by a fixed percentage (e.g., 1% to 5%) to help combat inflation. Adding such riders generally results in lower initial payout amounts.

Taxation of Immediate Annuities

The tax treatment of immediate annuity payments depends on how the annuity was funded. Annuities are categorized as either qualified or non-qualified, which dictates how income is taxed.

A qualified immediate annuity is funded with pre-tax money, often from retirement accounts like a 401(k) or traditional IRA rollover. The entire amount of each payment received from a qualified annuity is taxed as ordinary income, consistent with other pre-tax retirement vehicles.

In contrast, a non-qualified immediate annuity is purchased with after-tax money. For these annuities, each payment consists of a return of principal and taxable earnings. An “exclusion ratio” determines the tax-free portion, representing the percentage of each payment considered a return of the original principal investment. The remainder is subject to ordinary income tax rates. The exclusion ratio is calculated by dividing the “investment in the contract” (original after-tax premium) by the “expected return” (total anticipated amount over the annuity’s lifetime). This ratio ensures the annuitant is not taxed again on money already taxed.

Once the original principal has been returned through tax-free portions of payments, all subsequent payments become fully taxable as ordinary income. Income from annuities is taxed at ordinary income rates. For beneficiaries of an immediate annuity with a period certain or refund option, any payments received after the annuitant’s death are also subject to tax rules. If payments continue the original income stream, the tax treatment (exclusion ratio for non-qualified, full taxation for qualified) continues for the beneficiary.