An Explanation of Immediate Annuities
The recent, historic declines in the financial markets have caused millions of prospective retirees to reevaluate their retirement plans with most having to either delay retirement or find other means of meeting their retirement income needs. It has come to light that many of these pre-retirees are now in the precarious position of possibly outliving there income sources.
Younger generations must contend with an even longer period of uncertainty and also face the prospect of reduced benefits from a nearly bankrupt Social Security system. Immediate annuities have long provided a solution to lifetime income needs, and now, more than ever, will become the vehicle of choice for anyone concerned with the possibility of outliving their income.
With their prominence as a retirement solution increasing, it is more important than ever to truly understand how an immediate annuity fits into the planning scheme and how it can secure your retirement future.
An immediate annuity, as the name implies, is designed to produce an immediate stream of income for consideration of an immediate lump sum of money. By contract, the promised income becomes an obligation of a life insurance company that provides certain guarantees for future payments.
How Does an Immediate Annuity Work?
A lump of money is deposited with a life insurer which, using actuarial calculations based on life expectancy and project rates of interest, will convert it into a series of periodic payments, typically for the life of the annuitant. The life insurer assumes the risk that the annuitant could live beyond his life expectancy which would extend the obligation. If the annuitant lives for 10 years beyond his life expectancy, they stand to earn a substantial sum over their original investment and projected return.
Annuities can also be setup to pay out for a specific period of time, for instance a 10 year period.
Once the payments begin, 30 days after the deposit, the annuity becomes irrevocable; meaning that lump sum of money is no longer available to the annuitant except through the periodic payments. The payment amount and schedule is also locked in. The income from the periodic payments consists of both return of principal and interest earned. Only the interest portion is includable as taxable income.
Immediate annuities can be structured in several ways. The simplest form is a straight or single life annuity wherein the obligation of the life insurer is limited to a single person to his life expectancy. Immediate annuities can also be structured to protect the income of two lives, as in a husband and wife, through a joint and survivor arrangement. Under this arrangement, when the first annuitant dies, the life insurer is obligated to continue the payments to the surviving annuitant, albeit at a reduced rate of payment. A period certain arrangement guarantees that payments will be made for a specified period of time. The amount of the payment is based on a projection of the total amount of deposit plus earned interest that is available to be paid out.
Under these arrangements, when the annuitant(s) die, the life insurer keeps the remaining balance. Should there be any concern for the welfare a child, an installment refund arrangement will ensure that a portion of the principle balance will be paid to a named beneficiary. It's important to note that most of these arrangements that extend the obligation or risk of the life insurer over and above a single life arrangement will either reduce the payment amount or add some costs.
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Advantages of an Immediate Annuity Over Other Alternatives
Immediate annuities are very unique as a retirement vehicle, and in the right situation, they're unmatched in terms of providing a secure retirement income. Taken together, the key features of an immediate annuity provide advantages that can't be found in other retirement vehicles.
Safety - Principal is guaranteed by the life insurer backed by the strength of its underlying assets and its claims paying ability. Companies that are rated highly (A++ by A.M. Best) are considered to be extremely safe.
Lifetime income guarantee - No other vehicle can guarantee an income that will last as long as you do.
Favorable Tax Treatment - Interest earned on the principal is not currently taxed and, when the income payments are received, only the interest portion is taxed.
Competitive Returns - Life insurers tend to pay rates of interest that are highly competitive with CDs and other fixed yield investments.
Low Cost - There are usually no sales charges so 100% of your investment is applied to the income projection. There are mortality expenses but these are factored, actuarially, into the payment calculation.
How Do You Know If an Immediate Annuity is Right For You?
Immediate annuities are usually considered in the context of retirement planning, however, they are also used in any situation where there is a need for guaranteed payments for a specified period of time.
If you are near retirement and income security and stability are your primary concerns, then an immediate annuity should be considered. Because immediate annuities require a lump sum deposit, you would have to have available funds that can be moved. CDs, mutual funds, money market accounts, and qualified retirement accounts are typical sources.
It is not advisable to invest in an immediate annuity if, after the lump sum deposit, you are left with limited sources of available cash or liquid investments. Income from an immediate annuity should be thought of a supplement to your other sources of income and there should be ample liquid assets on hand that can be used for emergency spending as well as lifestyle purchases.
If the need for supplemental income is not immediate, it may be advisable to delay the purchase of an immediate annuity. Since the payout amount is based on life expectancy, the older you are when the annuity begins, the higher your guaranteed payout will be. Plus, the higher payout will consist of more return of principal which means taxable portion will be smaller.
Immediate annuities have moved to the forefront of retirement planning options , and, as uncertainty reigns, their use will increase. While they are not for everyone, if you are concerned that your money won’t last as long as you do, they can be indispensible for their ability to dispense a lifetime of income.
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