Annuitization explained: Pros, cons & the 10-year rule

There are so many different ways to plan for retirement that many Americans wrestle with where to start. One approach you might consider for your own retirement plans is an annuity.

This insurance contract allows purchasers to receive a guaranteed income stream after retirement. Following the passage of the SECURE Act in 2020, annuities are now sometimes included in 401(k) plans as well. As with a 401(k), the money you invest in an annuity will be paid back to you. That payout is called annuitization.

Annuitization is the process that converts the money you've invested in an annuity into regular payments as part of your retirement plan.

You can choose to spread the annuity payout over a specific period of time or across the rest of your lifetime. Some annuities will continue making payments to a beneficiary you name for the rest of the time period you've chosen if you pass away before it ends. This can act as a security blanket to help support, for instance, a special needs child or other family member without individual income.

An annuity is purchased with either a one-time payment or a series of payments. From there, those funds grow over time. Annuitization is the event that takes the value of the annuity and switches it into payout mode—giving you a nice, steady income you can count on. The annuity issuer will then make a calculation that looks at the annuity's value, your life expectancy and your chosen payout mode to determine how much those regular payments will actually be. Once that takes place, the plan begins making payments and is technically annuitized.

As you build the foundation for your life in retirement, there are many advantages to deciding to annuitize.

• Guaranteed income for life. Once you annuitize, you are guaranteed an income stream for the rest of your life (or for the period you determined). This can provide an extra layer of security for you and your family.

• Payout beyond purchase price. When you annuitize, the annuity will make those guaranteed monthly payments—even if the total payments across your lifetime exceed the purchase price you actually paid and the earnings for your annuity. This is why annuities qualify as life insurance products, even though you can (and in fact must, as discussed below) receive their benefits before you die. If you live a long life, you can reap a great financial payout.

• Low-maintenance management. You don't have to monitor a fixed or indexed annuity. Like any other investment, however, it makes sense to pay attention to variable products to monitor market movement and adjust if you choose. You simply get the payments as planned without much intervention once you've decided to annuitize.

Although the benefits are significant, consider the potential stumbling blocks.

• Payments end at death. Depending on the type of payout, the payments may end upon the death of the owner or their beneficiary. There is no inheritance left—the annuity just ends. If you don't live as long as your life expectancy predicts, you could lose out on those remaining funds.

• Accumulation ends. When payments begin, you can no longer add money to the annuity. However, those funds do continue to grow in value with the annuity's investment strategy.

• It is not liquid. Once you annuitize and start to receive payouts, there is no cash value left in the product. You cannot withdraw your principal unless you sell the annuity to a third party for less than it's worth.

• Fees. Some annuities charge high fees, including commission, that can impact the value of your investment. It's important to understand any required fees upfront.

• Non-Qualified annuity taxation.  If you have a non-qualified annuity no tax is owed until you begin receiving payments. You control when you will pay tax on the money by deciding when you want to annuitize. However, payments are taxed as ordinary income, not capital gains. Meaning, each distribution will be both earnings and the original contribution (not taxed). The earnings are taxed as ordinary income.

• Qualified annuity taxation. If you have a qualified annuity no tax is owed until you begin receiving payments. However, the IRS does require distributions begin at your RMD age. Typically, each distribution will be both earnings and the original contribution which will be fully taxable. An exception applies to Roth accounts. Contributions are distributed tax-free, and earnings may also be tax-free if you meet the requirements for a qualified distribution.

Yes, if you're planning on saving for retirement and are okay with the funds not being liquid long-term. Since annuities are set up to provide retirement income, if you take a withdrawal before age 59½, you'll face penalties or surrender fees from the annuity itself and from the IRS. That's why it's commonly thought of as a type of retirement account and not a general investment.

Beneficiaries of qualified annuities are subject to distribution requirements after the death of the owner. For distribution purposes, there are three categories of beneficiaries (designated, eligible designated, and non-designated.)

• Designated beneficiary's must take the full account value out by the tenth year. In some situations, beneficiaries may be required to take annual distributions over the 10-year period. Or they may opt for a lump-sum payout.

• Eligible designated beneficiaries must start distributions the year after the owner's death based on life expectancy or faster.

• Non-designated beneficiaries must take a lump sum by the fifth year after death.

Failure to meet distribution requirements leads to a 25% IRS penalty, or 10% if it's corrected during the correction window.

Beneficiaries of non-qualified annuities generally may be able to take annual distributions starting the year after the owner's death based on life expectancy or a lump sum within five years.

A qualified annuity is funded with pretax money (money you haven't paid taxes on yet) unless it's a Roth IRA annuity, which is funded with after-tax dollars.

Qualified annuity payouts can be taxable depending on how the annuity is funded. If you didn't have to pay taxes on the money ahead of investing it, you're required to pay taxes on it (plus the increase in value) upon withdrawal.

Annuities can be a sound way to plan for a guaranteed income stream after you retire. However, because annuities are a complex topic that can significantly influence your financial health and that of your beneficiary, consider the full range of options before making a decision. Talk with a financial advisor about your goals and whether annuitization is a good choice for your plans in retirement.