A Lesson in Immediate Annuities
Single Premium Immediate Annuities (SPIAs) are purchased with
a single deposit amount. As the name implies, the annuity usually
start making regular monthly payments to you immediately after
you turn over the funds to the insurance company. Typically this
means 30 days from the date of deposit; but within certain limits
you can also to defer the date that payments begin.
The first thing you need to understand is what actually happens
when you buy an immediate annuity. In return for a sum of money,
the insurance company promises to make regular payments to the
owner or annuitant (if different) for a specific period, such
as the remainder of the annuitant's life. The payments can be
set up in any of a variety of different ways (see below); however,
whatever form you do select at the time of purchase cannot be
changed at a later date. In accepting this guaranteed schedule
of payments you also give up the right to demand the return
of your original deposit, for example in the form of a lump
sum less any payments that have already been received. In short,
once the payments of an immediate annuity have begun, the contract
generally cannot be revised or cashed in.
The funds that are used to purchase an immediate annuity can
come from a variety of sources, including a maturing Certificate
of Deposit (CD); monies accumulated in a Deferred Annuity account
(see below); or a lump sum distribution from a tax-qualified
defined benefit or profit-sharing plan, or an IRA account.
Why should I consider buying an Immediate Annuity? What are
its advantages to me?
These are a many advantages that immediate annuities can provide
to the buyer. Here is a list of just a few:
Security- the annuity provides stable lifetime income which
can never be outlived or which may be guaranteed for a specified
Simplicity- the annuitant does not have to manage his investments,
watch markets, report interest or dividends;
High Returns- the interest rates used by insurance companies
to calculate immediate annuity income are generally higher than
CD or Treasury rates, and since part of the principal is returned
with each payment, greater amounts are received than would be
provided by interest alone;
Preferred Tax Treatment- it lets you postpone paying taxes on
some of the earnings you've accrued in a "tax-deferred"
annuity when rolled into an immediate annuity (only the portion
attributable to interest is taxable income, the bulk of the
payments are nontaxable return of principal);
Safety of Principal- funds are guaranteed by assets of insurer
and not subject to the fluctuations of financial markets; and
No sales or administrative charges
Single Premium Immediate Annuities (SPIAs) are particularly
suitable for the following situations:
Retirement from Employment;
Terminal Funding or Pension Terminations (including deferred
Retired Life Buyouts;
Structured Settlements for Personal Injury, Estate or Divorce
Professional Sports Contracts; and
Credit Enhancement and Loan Guarantee Transactions.
Forms of Annuity
The most basic life annuity is known by several names, including
"Single Life," "Straight Life," "Life
Only," or "Non-refund" annuity. In its simplest
form, it provides guaranteed payments over the lifetime of one
person, with payments ceasing upon the annuitant's death. By
offering a way of insuring that you will not outlive your financial
resources, a Single Life annuity can be an important tool in
planning for retirement. A Single Life annuity also provides
the highest payout of any lifetime annuity, because it carries
the smallest risk for the insurer.
One of the key factors in pricing a life annuity is the average
life expectancy of the person that will be receiving the payments.
In a sense, purchasing a life annuity is like making a bet with
an insurance company about how long you will live. Since the
insurer will stop making payments when you die, it is betting
that you won't live beyond your life expectancy. On the other
hand, you come out the winner if you do live longer than the
average person, because the insurance company will have to continue
making payments beyond the period it had assumed.
The coverage of a life annuity can be increased by including
a second person ("Joint and Survivor" annuity), by
adding a guaranteed period of time ("Period Certain"
annuity), or by guaranteeing that payments will continue at
least until the original purchase amount has been paid out ("Installment
Refund" annuity). The added risk to the insurer is likely
to reduce monthly payments by about 5% to 15%, depending on
the age of the annuitants and the length of the guarantee period.
Annuities with this kind of added coverage are particularly
suitable: (1) when there is a need to guarantee income over
the lifetimes of a husband and wife ("Joint and Survivor"
annuity); (2) when payments must continue for a specified period
(e.g. 5 or 10 years or more) to a designated beneficiary ("Certain
and Continuous" annuity); or (3) when the annuitant wants
to make sure that, if he should die before his initial investment
has been fully distributed in monthly payments, an amount equal
to the balance of the deposit continues to a named beneficiary
("Installment Refund" annuity).
Funds That Purchase an Immediate Annuity
Source of Funds - Qualified vs. Non-Qualified
Qualified Immediate Annuities
The term Qualified (when applied to Immediate Annuities) refers
to the tax status of the source of funds used for purchasing
the annuity. These are premium dollars which until now have
"qualified" for IRS exemption from income taxes. The
whole payment received each month from a qualified annuity is
taxable as income (since income taxes have not yet been paid
on these funds). Qualified annuities may either come from corporate-sponsored
retirement plans (such as Defined Benefit or Defined Contribution
Plans), Lump Sum distributions from such retirement plans, or
from such individual retirement arrangements as IRAs, SEPs,
and Section 403(b) tax-sheltered annuities, or Section 1035
annuity or life insurance exchanges. Generally speaking, insurance
companies use male/female (sex-distinct) rates to price qualified
annuities in situations where the purchaser and/or owner is
a corporation. When the annuity is being purchased by an individual,
annuity rates are generally unisex. Some states, however, require
that unisex rates be used for all qualified annuities.
Non-qualified Immediate Annuities
Non-qualified immediate annuities are purchased with monies
which have not enjoyed any tax-sheltered status and for which
taxes have already been paid. A part of each monthly payment
is considered a return of previously taxed principal and therefore
excluded from taxation. The amount excluded from taxes is calculated
by an Exclusion Ratio, which appears on most annuity quotation
sheets. Non-qualified annuities may be purchased by employers
for situations such as deferred compensation or supplemental
income programs, or by individuals investing their after-tax
savings accounts or money market accounts, CD's, proceeds from
the sale of a house, business, mutual funds, other investments,
or from an inheritance or proceeds from a life insurance settlement.
While most insurance companies apply their male/female (sex-distinct)
tables to non-qualified annuities, some states require the use
of unisex rates for both males and females.