Some income annuities have fixed income requirements, making them useful to help fund early retirement or pre-fund a large loan or life insurance policy.
Immediate income annuities with lifetime payouts are popular for good reason. By providing an immediate monthly income guaranteed for life, they help ensure a worry-free retirement.
But you don’t have to choose the lifetime option. Instead, you might want to choose a fixed income term, from five to 20 years. Sometimes it makes perfect sense to choose an income annuity for a certain period.
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For example, you might need extra income to fund early retirement until Social Security and/or a company pension kicks in. Or you can delay taking Social Security until age 70 to maximize your income benefits. Or you might want to pre-fund a large loan or life insurance policy that requires payments over a set period of time.
Period Some income annuities offer a high guaranteed income
An immediate pension (opens in a new tab) is purchased with capital, which is why it is called a single premium immediate annuity (SPIA). Whether it’s for life or for a fixed term, it generally has no cash value after purchase. You have handed over your money to an insurance company in exchange for a guaranteed income stream.
With a lifetime income SPIA, a cash refund option ensures that your premium payment will not be lost in the event of premature death. If you die before your monthly payments match the full amount of the purchase price of your annuity, your beneficiary will receive the difference.
You can also choose to add your spouse, so that they continue to receive income after your death, assuming you predecease them. This option usually lowers your payments slightly.
With a fixed term annuity, depending on your age at issue and the payment duration selected, you will generally get larger monthly payments than with a lifetime variety because the insurance guarantees income for a period determined, and not for your life. The shorter the period, the higher the annual or monthly income.
You will get a much higher guaranteed income than with other alternatives. This is partly because with a fixed term annuity, if not eligible, most of the income you will receive is a tax-free refund of your principal, and the rest is taxable interest. (When the annuity is held in a qualified retirement plan such as a traditional IRA or 401(k), the payments are fully taxable.) Bank certificates of deposit, for example, do not provide a similar amount of income because you can only take interest unless you are prepared to pay a large penalty to the bank. Otherwise, you must wait until maturity to recover your capital.
The other reason annuities produce more income is that they generally pay significantly higher underlying interest rates than bond funds, CDs, and money market accounts.
Also, you don’t get similar guarantees. Money market rates fluctuate; Bond fund prices vary.
Let’s see some possible uses.
Income for early retirement
For example, suppose you want to retire now but delay your Social Security participation by eight years. You could buy an annuity term certain for eight years to close your income gap.
Here is an example. 60-year-old Joe retires and invests $200,000 over eight years in an immediate certain annuity and enrolls his wife as joint annuitant so she’s protected and continues to receive remaining payments if he dies before the end of eight years. With this type of annuity, he can accurately calculate his annual return.
Joe will receive $2,471.21 per month, including $2,083.33 in principal and $387.88 in taxable interest. After eight years, he will start collecting social security and will not need the additional income.
Pre-fund installment payments for a Big life insurance policy or loan
Suppose you decide to take out a large life insurance policy. Rather than fund the policy with a single premium payment, you can purchase a term certain annuity for 10 years with annual payments that you will use to make premium payments over time. This way, you can avoid the life insurance policy being categorized as Modified Endowment Contracts (MEC), which can be disadvantageous from a tax standpoint.
Or let’s say you have a substantial loan with a prepayment penalty. Rather than repaying the loan and incurring the prepayment, you can purchase a term annuity to pre-fund the remaining payments.
Here is an interesting income strategy that combines two types of annuities.
Let’s say you have $100,000 to deposit and your combined federal/state tax bracket is 28%. How can you maximize your guaranteed after-tax income?
You could simply buy a 10-year fixed rate annuity (opens in a new tab) giving 5.20%. A fixed rate annuity acts much like a bank CD: you deposit a lump sum and the insurer agrees to pay a fixed guaranteed rate of interest for the term.
You could then make annual interest withdrawals of $5,200. These withdrawals are fully taxable, resulting in additional taxes of $1,456, giving you net after-tax income of $3,744.
Here is an alternative. Instead, you would put $60,234 into the fixed-rate annuity and the balance, $39,766, over a 10-year period, some immediate annuity paying an annual income of $5,010. Of this amount, $1,032 is taxable and $3,978 is non-taxable
The $60,234 allocated to the fixed rate annuity grows tax-deferred so that it will equal your original $100,000 after 10 years.
At first glance, it would seem that putting all the money in a fixed rate annuity generates more income than the split annuity strategy. However, with the split strategy, only $1,032 of the annual income payment is taxable because the rest of the payment is a refund of your premium deposit. As a result, only $289 in annual taxes are owed, leaving a net after-tax income of $4,721, or $977 more than if you put all the money into a fixed-rate annuity.
In retirement, most people rely on a combination of social security, retirement plans, and personal savings to earn a living. A split annuity strategy can help supplement these sources, add stability and ensure that you don’t outlive your assets.
The vast majority of immediate annuities purchased include some type of lifetime payout configuration. But they are not the only good income solution. Review your situation and speak to an experienced pension advisor. You may find that a certain annuity period fills the bill.
This article was written by and presents the views of our contributing advisor, not Kiplinger’s editorial staff. You can check advisor records with the SEC (opens in a new tab) or with FINRA (opens in a new tab).
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