Immediate Annuities

It’s possible to get a high fixed return on your money with an immediate annuity to provide retirement income. An immediate annuity is simply the payment of a premium to an insurance company.  In exchange, the company converts your premium to a monthly income for life.  You cannot outlive this retirement lifetime income! (Monthly payments are based on the claims-paying ability of the insurer, so picking a financially solid insurance company is important.)

Here’s a hypothetical example. A 76-year-old gentleman paid $50,000 in premium to an insurance company. He now receives $388 retirement income per month, every month. That’s $4,656 each year of checks in the mail. For $50,000 where else can you get guaranteed $4,656 every year for the rest of your life?

Regardless of how long he lives, he gets his check every month. If he dies early, his beneficiaries will receive the $388 monthly until $50,000 in payments have been received in total. This is called the “installment
fund” provision. (If the owner does not need or does not elect the installment refund provision for his beneficiaries, the monthly payments would be even higher at $473 per month.)

For whom is an immediate annuity suitable?

• A retiree needing increased monthly retirement income
• A person with no heirs or who is not concerned about leaving an estate
• Someone who has set aside other funds to leave to heirs if they desire to leave an inheritance
• A retiree desiring the fixed payment and wanting to avoid maturities, rolling over investments and the maintenance and administration required of investing on one’s own

Your immediate annuity may give you a double tax break

If you’re concerned about having enough income to last and you want to maximize it – perhaps an immediate annuity is for you. You’d ensure an income for life but it’d depend on your age and sex. When you die, that’s it-your investment is gone. But this may be fine in your case and in other cases rules out the use of immediate annuities.

What are the tax consequences?

The money in your immediate annuity will grow at a fixed rate while you take your payouts. Each payout has both a taxed and untaxed portion. The untaxed part is your basis-i.e. your purchase price. Its fraction of each payout – called the exclusion ratio – remains fixed at the ratio of your purchase price to the expected total payout based on your remaining life expectancy.

For illustration purposes, we’ll estimate the total payout for 15 years for a 65 year old male living in California who invests $100,000 – based on a leading supplier of immediate annuity quotations . Fifteen years is the IRS table’s expected life at of a 65 year old man. Their estimate gives $675/month-with no beneficiary (lower payouts would include guaranteed term payouts to beneficiaries). The total payout over 15 years at $675/month is $121,500. So the exclusion ratio is 82.3% (= $100,000/$121,500)!

So, your annual income from your $100,000 immediate annuity investment is $8,100 of which only $1,434 is taxable. At a 25% marginal tax rate, you net about $7,700 per year. Not a bad cash flow!

If you had invested your $100,000 in 10 to 30 year corporate bonds at the prevailing 5% rate, you’d generate a $5,000 yearly income but all of it taxable. Again at a 25% marginal tax rate, your net income is $3,750-about half as much as you net from your immediate annuity.

Purchasing tax free bonds- at a lower prevailing interest rate- may give you more net income, but still significantly less cash flow than from your immediate annuity.

Further possible tax savings on taxable social security

Social security becomes subject to tax for provisional incomes beyond $25,000 for single individuals, and $32,000 for married filing jointly. It can be taxed up to 85% beyond the $34,000 and $44,000 thresholds respectively. This provisional income includes all taxable income, 50% of your social security income, and tax free bond income.

Your immediate annuity income adds only $1,434 to your provisional income compared to $5,000 from 5% tax free bonds or corporate bonds. If you’re near or within the above threshold levels, you’ll reap additional tax savings from social security income that remains untaxed due to your immediate annuity’s lower contribution to provisional income. That tax savings can be substantial too.