It is likely that your parents or grandparents retired with a pension benefit that guaranteed a monthly check for the rest of their life. Times have changed, however, and most companies no longer offer traditional pension plans; the retirement savings burden has slowly shifted to the employee.
For more on how employer-sponsored pensions have changed, see The Decline of Employer-Sponsored Pension Plans.
Although you might be able to amass substantial retirement assets in your 401(k) and other vehicles, how will you convert these assets into an income stream during retirement? You might consider converting at least a portion of your retirement savings into a guaranteed lifetime income stream — your own version of regular "pension" payments.
To learn about annuity options and how they fit into a retirement strategy, see Income Annuities.
Creating an Income.
When you purchase an immediate annuity, you pay a lump sum to the issuing insurance company in exchange for monthly income payments. These monthly payments are guaranteed to continue for as long as the annuity contract specifies.*
Many immediate annuities offer a choice of payout options. For example, you might choose income payments that last for the rest of your life, or over the joint lifetimes for you and a beneficiary, such as your spouse. Monthly payments received under the joint-lifetime option are smaller than with a single-life only payout plan, but offer a way to provide an income stream to a surviving spouse.
Another option is to elect income for your lifetime with a period certain option. For example, if you elected a 10-year period certain option and you died before the end of 10 years, your beneficiaries would continue to receive payments until the period certain option expired.
How Payments Are Taxed.
If your annuity was purchased with after-tax dollars, a portion of each income payment is considered a tax-free return of principal. The rest is subject to ordinary income taxes. Payments received from annuities funded with before-tax IRA assets (Traditional IRAs, 401(k)s, etc.) would be fully taxed as ordinary income.
Suitable for You?
Immediate annuities can offer retirees a measure of stability and predictability in a world of financial uncertainty. However, as with any financial product, they are not an appropriate solution for everyone. The fixed income payments might not keep pace with inflation (unless the annuity contract includes an inflation rider). Also, you might not be able to withdraw principal or change the payout amount, should you ever need more money. Some immediate annuities do offer special withdrawal features, but such flexibility usually reduces the monthly payments.
For context on how annuities are used in retirement planning, see The Role of Annuities in Retirement Planning.
So, if you're interested in taking guaranteed payments from a lump sum of existing assets, give an immediate annuity a good look. A financial professional can show you available income options specific to your situation and explain more of the benefits these unique products have to offer — or you can talk to an agent.
* Annuity withdrawals are generally taxed as ordinary income and may be subject to surrender charges, in addition to a 10% federal income tax penalty if made prior to age 59 1/2. The guarantees and payments of income are contingent on the claims paying ability of the issuing insurance carrier.
Frequently Asked Questions
What is an immediate annuity?
An immediate annuity is a contract where you give an insurer a lump sum in exchange for regular income payments that begin right away and continue per the contract terms.
How are annuity payments taxed?
Payments from annuities bought with after-tax dollars include a tax-free return of principal portion, while payments from pre-tax accounts are generally taxed as ordinary income.
Will annuity payments keep up with inflation?
Not usually; fixed payments do not adjust for inflation unless the contract includes an inflation or cost-of-living rider, which can reduce initial payment amounts.
Can I access my principal after buying an immediate annuity?
Most immediate annuities restrict withdrawals and changes after purchase, though some offer limited withdrawal features that typically lower the guaranteed payments.