What’s an immediate annuity?

When you are approaching retirement, you may want to purchase an immediate annuity contract to turn your retirement savings into guaranteed income streams. Generally, the immediate annuity may be funded by a lump sum payment from a savings account or a retirement account.

An immediate annuity is an insurance contract between an individual and an insurance company, which guarantees income payments starting almost immediately in exchange for a lump sum payment. The income payments last for a set number of years, or over your lifetime. An immediate annuity pays a guaranteed income stream to help retirees supplement their retirement income.

How does an immediate annuity work?

An immediate annuity is an insurance contract between an insurance company and an individual, also known as the annuitant. The insurance company pays the annuitant a guaranteed income almost immediately in exchange for an initial lump sum payment. The annuitant can choose to be paid monthly, quarterly, or yearly.

The insurance company calculates the income payments amount based on several factors such as your age, how long the payments will last, and the prevailing interest rates. The immediate annuity payments are generally fixed for the term of the contract, but some insurers offer variable annuities that change based on the performance of the underlying securities. Apart from variable annuities, insurers may also offer inflation-adjusted annuities, which adjust payments with changes in the rate of inflation.

Immediate annuities are popular among retirees looking to supplement their other retirement incomes like pension, Social Security, and retirement plan distributions. They can spread the annuity payments over their lifetime or for a limited period like 5 or 10 years.

Immediate vs. Deferred annuity

An annuity is a contract between an individual and an insurance company, where the insurer makes payments to the individual either immediately or in the future, depending on the type of annuity.

An immediate annuity provides income payments almost immediately, usually within a year of purchasing the annuity, but it could be as early as after you sign up. An immediate annuity has no accumulation phase, and it is ideal for people who are looking to supplement their retirement income immediately.

However, with a deferred annuity, there is a delay in making annuity payments, usually after at least one year or longer. This option allows insurers to invest and grow the money, and you will receive increased payments than if you opted for an immediate annuity.

Types of immediate annuities

When you buy an immediate annuity, you should understand how your annuity is classified to determine what your future payments will be. The annuity rate of return may be categorized into either fixed or variable.

Fixed immediate annuities

A fixed immediate annuity provides a fixed guaranteed interest for the duration of the annuity contract. The guaranteed interest rate on your annuity stays the same for a year or the full duration of the guarantee period. The fixed interest rate eliminates any risks associated with market volatility, but there is a risk of inflation decreasing the value of your funds. If you want your retirement income to last throughout your lifetime, a fixed immediate annuity may be a good option.

Variable immediate annuities

When you purchase a variable immediate annuity, your investments are held in sub accounts, which invest in various assets like stocks, bonds, and money market funds. Generally, the return you earn on your deposit is based on market performance; if the investments do well, you will get higher monthly payouts, while poor investment performance will result in lower annuity payouts.

Inflation-indexed annuity

An inflation-indexed annuity falls between variable and fixed annuity, and it earns interest based on how the market performs. Generally, an inflation-indexed annuity pays you a guaranteed income for the rest of your life, but the payments increase or decrease each year depending on the rate of inflation. However, this annuity caps the potential gains or losses, and the rate of interest is guaranteed not to fall below zero.

Pros of Immediate annuities

Below are the benefits of investing in an immediate annuity plan:

Tax advantages

Immediate annuities enjoy a tax-deferred status, meaning you will only pay taxes when you withdraw earnings. This allows you to benefit from compounded growth of both principal and interest earnings. Also, if you fund the immediate annuity with money you’ve paid income taxes on, you won’t pay taxes again when you withdraw the principal; you will only pay taxes on the interest earnings.

Immediate income

Once you retire, you will no longer receive a salary from your former employer. However, if you invest in an immediate annuity, you will continue receiving regular payments immediately, or within one year after purchasing the annuity. It is a good option if you need money right away.

Simplicity

Once you purchase an annuity, you won’t need to do anything else like monitor your account or rebalance your investments. You will continue receiving regular payments from the insurer either monthly, quarterly, or annually, without any effort from you.

Lifetime earnings

If you choose an annuity with lifetime payments, you will receive guaranteed payments over your lifetime, and you are less likely to outlive your retirement income. Also, if you set up the annuity as a joint annuity, payments will continue for as long as you or your partner live.

Customizable

When you purchase an immediate annuity, you can choose between different types of annuities and payment options. You can also purchase additional features to add extra benefits like an inheritance for your beneficiaries or protection against inflation.

Cons of immediate annuities

Reduce cash liquidity

When you purchase an immediate annuity, you lose access to the money and you won’t get access to the deposit immediately. If you have an emergency, you may need to pay a big penalty to break the annuity contract.

High costs

You need to have saved a considerable amount of money to purchase an immediate annuity all at once. You may be forced to tap into your savings accounts, IRA, 401(k), or other retirement accounts to afford the upfront cost.

No accumulation

When you purchase an annuity, you will start receiving payments almost immediately. This means there is no accumulation phase, and your money has limited opportunities to grow.