How Does an Immediate Annuity Work?

Written by Hersh Stern Updated Saturday, September 16, 2017

If you’ve been considering annuities, you may have discovered that there are a number of different types of annuities, each designed to address the needs of particular groups of individuals at a certain time in their lives.

When it comes to retirement income, not only does the immediate annuity offer the right benefits for many retirees, but it has the added advantage of being one of the most straightforward and easy to manage of all the annuity products.

While a life insurance policy will protect against a policyholder dying too soon, an immediate annuity actually protects against “living too long.” The rates are based on your life expectancy; live longer, and the annuity can provide an outstanding rate of return.

Immediate annuities address a pressing worry for many retirees: How do I keep from outliving my savings?

To begin the immediate annuity process, you should speak with an advisor about your financial situation with attention to three important pieces of information:

1. Your age

2. Your current liquid assets

3. Your retirement goals, including a budget for your lifestyle, future plans (such as vacations and home renovations) and how you may want to provide for beneficiaries

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In addition, you will want to factor in any special provisions. A traditional immediate annuity provides a straightforward fixed income for the life of the policyholder.

However, today, insurance companies have structured immediate annuities to offer many more options. Some are structured to continue payouts for a surviving spouse, while others even offer a limited liquidity option if you have a "cash emergency."

Once you have purchased the annuity that is right for you, it is very simple to manage. The annuity will pay you a fixed income on a regular basis (this can be monthly, quarterly, or annually).

There is no need to follow the markets or worry about changes in interest rates. While many consider this to be a “get it and forget it” type of product, I do always recommend that annuity holders still speak regularly with an advisor to review any changes in their goals or financial situation.

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Comments (13)

  1. Grant:
    May 27, 2015 at 12:37 PM

    My total premium is a mix of pretax IRA and after-tax savings and some stocks. How do we account for the difference in sources?

  2. Hersh Stern:
    May 27, 2015 at 12:43 PM

    Hi Grant-

    Regarding the different sources of funding – you will need to purchase two annuities. One funded with IRA (so-called pre-tax or “qualified”) monies. And a second funded with your after-tax savings (or, “non-qualified”) monies.

    Overall, the two annuities will give you nearly the same total income you would have received if you purchased one large annuity.

    The reason for allocating your premium to the purchase of two annuities instead of one is that the tax treatment of the income you receive from these two annuities is different.

    The income you get from your IRA annuity is fully taxable. At the end of the year, you receive a Form-1099-R from the insurance company which will show the year’s income is fully taxable.

    However, the second 1099 for the “non-qualified” annuity will indicate that only a fraction of the total income received during the previous year is taxable. The taxable portion reflects the new interest you earned in your annuity. Whereas that part of each month’s income which represent a return of your original (already-taxed) money is NOT subject to taxes when the company pays it back to you.

    P.S. - Regarding the stocks, in order to buy an annuity you'll need to cash these out. An annuity can only be purchased with cash. If your stocks are an IRA account, then of course they're treated the same was as any other IRA. If your stocks are in a non-IRA account, then once you cash them out they have the status of "non-qualified" savings (even if you haven't yet paid capital gains tax).

    Hersh

  3. Robert:
    Jun 01, 2015 at 04:25 PM

    Do you have an immediate annuity that you could recommend with a LTC option?

  4. Hersh Stern:
    Jun 01, 2015 at 04:32 PM

    Hi Robert -

    You asked about LTC options combined with immediate annuities. Generally, most clients that ask this question are referring to a feature where the insurance company permits you to accelerate your monthly annuity payments if you’re confined to a nursing home. It’s not that the company will pay your nursing home rent, as an LTC insurance policy does. It’s just available for you to request one large advanced payment above what you ordinarily receive each month.

    If this is what you had in mind, then, yes, a few of the companies we represent do offer accelerated payment features in their immediate annuity contracts, which frankly, you can exercise even if you’re not confined to a nursing home. These options are available to any annuity owner for any purpose.

    Keep in mind, too, that the amount this feature permits you to withdraw is limited to only a small portion of your premium. Also, when the company pays you the cash advance, it reduces the amount of your regular monthly payment to offset the amount paid in the lump sum.

    There are other types of annuities which offer penalty-free nursing home or terminal illness withdrawals. Fixed index annuities with income riders are amongst them. You can see more information about them here:

    https://www.immediateannuities.com/fixed-index-annuities/

    -Hersh

  5. John:
    Jun 12, 2015 at 02:49 PM

    My wife is one of several beneficiaries of her parent's trust. She is 64 years old. Can she use an immediate annuity to spread her portion of distribution over multiple years to minimize the taxes. If so, should she be the owner and annuitant with her spouse (me) as beneficiary?

  6. Hersh Stern:
    Jun 12, 2015 at 02:50 PM

    Hi John-

    The subject of taxes and trust distributions is very complex. I strongly urge you to consult with a tax attorney or CPA to get reliable answers to your question.

    I can tell you this. You’re right that an immediate lifetime annuity can spread the taxes on gains from, say, a previously-owned deferred annuity (if it’s exchanged under Section 1035 of the IRC). But I don’t know how your wife can use an annuity to avoid taxes on her share of the gains in the trust because she would have constructive receipt of her share of the trust gains before buying the annuity. So income taxes would become due before she’s had a chance to move any of the money into an annuity.

    If you’re thinking that the trust should buy the annuity and then transfer it to her, that scenario has it’s own set of complications. I think you’d be best served by discussing your question with a competent tax professional. I can certainly help you to purchase an annuity but you should first confirm that buying an annuity will minimize your taxes.

    -Hersh

  7. Leslie:
    Jun 17, 2015 at 04:17 PM

    I’m 50 years old. I inherited a non-qualified annuity and opted to take payments for the rest of my life. The original premium my dad paid 19 years ago was $18,000. The policy value increased to $48,580. The company told me the tax-free portion of my annual payments will only be $288.85. This looks wrong. If I divide that into $18,000 it will take 63 years or until I’m 113 years old to recover the premium --- is there an error in this calculation?

  8. Hersh Stern:
    Jun 17, 2015 at 04:17 PM

    Hi Leslie-

    I agree with you. Calculating 63 years for a 50 year old to recover the cost basis doesn’t make sense. Best to call the company and point that out to them. BTW, ask to speak with a supervisor who understands the concept of exclusion ratios as it applies to immediate annuities. Otherwise you may not get the right response.

    Hersh

  9. Leslie:
    Jun 17, 2015 at 04:19 PM

    Thanks for your reply, Hersh. I called the insurance company this morning and indeed a mistake was made and they're sending me a new settlement contract.

    I really appreciate your answering my question. Thanks again!

  10. Geoff:
    Aug 10, 2015 at 03:36 PM

    How easy would it be to put more money into an existing immediate annuity policy? Or would I have to just get a new policy with the same insurance company? Just hoping to cut down a little paperwork.

  11. Hersh Stern:
    Aug 10, 2015 at 03:37 PM

    Hi Geoff-

    Immediate annuities are only sold as “single premium” products. This means the policy is “locked” so you’ll need to apply again to buy a second contract. There are annuities which are called “flexible premium” policies, but immediates are not that type.

    Hersh

  12. Vicki:
    Oct 02, 2015 at 04:07 PM

    Does the annuity application assess eligibility? I was told I had to be regarded as eligible.

  13. Hersh Stern:
    Oct 02, 2015 at 04:07 PM

    Hi Vicki-

    Yes, there is a section on the annuity application that asks information about your finances so the insurance company can determine whether or not buying their annuity is a suitable purchase in your situation. You will be asked to provide information about your income, assets, liabilities, and the like. These are the types of questions you’ll find on the application. There are no questions which specifically ask about your health, if you were wondering about that.

    It’s important to remember that when you buy an immediate or deferred income annuity, you are surrendering your premium. As a result, you cannot access that money in case of emergencies. Generally, the companies want to be sure that that you have sufficient liquidity or emergency cash to cover unexpected expenses which may arise.

    -Hersh