As you consider an annuity as a source of retirement income, one of the most important factors to weigh is when you'd like payouts to begin and how long you'd like them to last.
You initially may think about life expectancy and your ideal retirement lifestyle. However, this is just scratching the surface—there are multiple annuity payout options to consider, allowing you to find the right fit for your personal financial situation. Here's how annuities work and strategies for choosing the right payout option for you.
How do annuities work?
An annuity is a series of fixed payments, typically paid out on a periodic basis for the rest of your life. It works as a contract between you and an insurance company and can be funded with a single lump sum or with multiple contributions; from there, you can elect to convert an annuity into an income stream by either making withdrawals as needed or receiving guaranteed payments for a set period of time (such as 25 years or even the rest of your life).
Annuities can be immediate, which means they are funded with a lump sum and immediately annuitized (converted into a series of periodic income payments), or they may be funded over a period of time by deposits. Once it is annuitized, the annuity no longer can accept additional deposits. The growth of annuities can come from investing in the market, or annuities may grow at a rate tied to a specified index. Some annuities are funded from retirement accounts, such as a 401(k) plan.
Kinds of annuities
There are four main
immediate annuity,also called a single payment immediate annuity(SPIA), is an insurance contract funded by a single lump sum, such as money from savings, inheritance or a 401(k). You decide on the frequency and duration of your payouts when you fund it.
deferred annuitycan be funded by a single payment but is usually built up with smaller amounts over a period of months or years. The funding period is called the accumulation phase, when the deferred annuity grows in value.
fixed annuityoffers a specific rate of return on the amount that's invested, typically over a set period of time. With a fixed rate, you know exactly how much you can earn each year and plan your financial future accordingly. This makes fixed annuities a popular choice for retirement.
variable annuityoffers potential returns that are determined by investments in the market. While the risk of fluctuations can result in lower gains or even losses, that same market risk can result in higher returns that can translate to higher payouts.
What are the types of annuity payouts?
Instead of taking withdrawals, annuities can provide various payout options, which also are called "settlement options." These payout options can create income either for life or for another specified period of time. Your choice of annuity payout can significantly influence your long-term financial outlook, so it's important to understand the full range of options.
Fixed period income
Also known as "period certain," the fixed period income payout option provides periodic income payments during the time period you select, such as 10, 15 or 20 years. The dollar amount of the payments is only calculated once you choose the time period.
Specified amount income
Also called a fixed amount systematic withdrawal schedule, a specified amount income payout provides a specific dollar amount for each of your periodic payments. Once you select a desired dollar amount, payments continue until you stop them or run out of money—meaning that this payout option is not guaranteed to last your entire life.
Life income agreement
Also called "life only" or "single-life," the life income agreement option provides guaranteed income for as long as you live. With this option, you also may choose a guaranteed payment period.
The payment amount is typically decided by your life expectancy, which means the longer your life expectancy, the smaller the periodic payments may be. If you do not live as long as expected, it's possible you won't get the total amount you originally accumulated. However, if you live longer than expected, you could receive more than the accumulated value of your annuity.
Joint life income
Also called a
Flexible payout deposit
The flexible payout deposit agreement (FPDA) option provides a place for proceeds from life and annuity contracts to accumulate an amount of interest at a guaranteed rate. You can choose the amount and frequency of the payouts.
Deferred income settlement option
A deferred income settlement option, or DISO, is intended to hold death proceeds from inherited deferred annuity contracts on a tax-deferred basis. A DISO payout provides up to a five-year tax-deferred holding option for your beneficiaries.
Annuity payout options: Factors to consider
When planning for your annuity payout, consider whether potential options make sense with your needs and goals.
- Retirement income needs. Knowing
how much you need to retirecan help you determine what size of annuity payments you'll need to supplement your income. This also can help you plan how much to accumulate in a deferred annuity, what rate of return you may need in a variable annuity or the rate of interest required in a fixed annuity to reach your retirement goals.
- Life expectancy. Shorter payout periods generally mean that the periodic payments you or your beneficiaries receive are higher. However, if you want your annuity payout period to last your entire life, you'll need to estimate your life expectancy.
- Five-year rule. This rule states that the beneficiary or beneficiaries of an
inherited annuityhave five years to withdraw the proceeds of an annuity after the owner's death.
- Taxes. Annuities grow tax-deferred, which means you don't have to pay taxes until you take a distribution, whether through a payout option or as a withdrawal. If you contributed the money with after-tax dollars, the amount you contributed (the principal) is not taxed, but the growth is taxed as ordinary income. If you funded the annuity with a pre-tax (qualified) plan such as a 401(k), the full payout is taxed as ordinary income.
Annuity withdrawal penalties and charges
Guaranteed annuity payouts can be smart income tools. However, there are times when you may need to make
Annuity withdrawals also may be subject to surrender charges, which may be imposed within an amount of time called the surrender period. The length of the surrender charge period varies among insurance companies but is generally between 6 and 10 years. The amount of the surrender charge is typically a percentage of the amount you withdraw, and the percentage generally declines the longer you've held the annuity.
For example, you might be charged a 7% surrender charge if you withdraw funds from an annuity in year one, and the charge may decline by 1% each year until after the seventh year when there would be no surrender charge.
Annuities play an important role in savings
Annuities are designed to provide a stream of income that lasts for a certain period of time, possibly even for the rest of your life. Annuity payout options can supplement other sources of income and help with retirement planning, especially if you're worried about outliving your savings.
Since there are many factors to consider when choosing the right annuity for you and your family's needs, proper planning is essential. Before you start looking over your settlement options, consider