Banking » Investing » What Is An Income Annuity?
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What Is An Income Annuity?

An income annuity converts your lump sum of money into a steady stream of income that can last for a specific period or the rest of your life.
Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
Interest Rates Last Update: April 15, 2024
The banking product interest rates, including savings, CDs, and money market, are accurate as of this date.
Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
Interest Rates Last Update: April 15, 2024

The banking product interest rates, including savings, CDs, and money market, are accurate as of this date.

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What Is A Income Annuity?

An income annuity is an insurance contract that converts your lump sum of money (or a series of payments) into a steady stream of income that can last for a specific period or the rest of your life. In return, you give up the right to access your money in a lump sum.

It is a type of annuity that is commonly used as a tool for retirement planning and to ensure a steady income during one's retirement years.

There are two main types of income annuities:

  • Immediate annuities start paying you income right away, typically within one month of purchase. This type of annuity is a good option for retirees who want to start receiving income as soon as possible.
  • Deferred annuities don't start paying you income until a later date, such as when you reach a certain age or retirement. A deferred annuity is a good option for people who want to grow their money tax-deferred before they start receiving income

How Does Income Annuity Work? Example

Let's walk through a simple example of how an income annuity works.

Jane is 65 years old and has just retired. She wants to ensure she has a guaranteed income for the rest of her life to cover her basic living expenses. Jane decides to purchase a single-life income annuity with a lump-sum payment of $100,000.

Jane contacts an insurance company that offers income annuities. She provides them with the required information, such as her age, the amount she wants to invest ($100,000), and any additional options she wants to include (e.g., inflation protection, joint and survivor benefit).

Jane decides to start receiving income from her annuity at age 70. She chooses a single-life income annuity, which means the payments will continue for her lifetime but won't be passed on to beneficiaries.

The insurance company uses actuarial tables to determine how much monthly income Jane will receive based on her age, the total accumulated value of the annuity, and other factors. Let's assume the insurance company offers a monthly payment of $800.

Jane starts receiving her monthly income of $800 from the annuity. This payment will continue for the rest of her life, regardless of how long she lives.

Even if the accumulated value of the annuity is depleted due to payments made, the insurance company is obligated to continue the payments for as long as Jane lives.

Pros And Cons Of Income Annuity

Income annuities can be a valuable retirement planning tool for some individuals, but like any financial product, they come with their own set of advantages and disadvantages. Let's explore the pros and cons of income annuities:

Benefits
Drawbacks
Guaranteed Income
Loss of Control
Simplicity
Inflexibility
Protection From Market Volatility
Inflation Risk
Limited Potential for Inheritance

Once you purchase an income annuity, you are guaranteed to receive a specific amount of income each month for the rest of your life. 

This can provide peace of mind knowing that you will have a steady income stream no matter how long you live.

Income annuities are relatively straightforward compared to other investment products, making them easy to understand for individuals who prefer a simple retirement income strategy.

Income annuities can protect your retirement income from market volatility. 

If the stock market crashes, you will still receive your guaranteed income from your annuity.

Once the lump sum is invested in the annuity, the annuitant typically loses access to that principal. 

This lack of liquidity can be a drawback for those who might need access to their savings for emergencies or other purposes.

Income annuities are generally inflexible, meaning it's challenging to change the terms or adjust payments once the annuity contract is in place.

Unless the annuity offers inflation protection, the purchasing power of the fixed payments may erode over time due to inflation.

With single-life annuities, the payments stop after the annuitant's death, and there may be little or no money left to pass on to beneficiaries.

Purchase Income Annuities: Things To Consider

When considering investing in income annuities, there are several important factors to take into account to ensure that it aligns with your financial goals and retirement needs. Here are some key things to consider before purchasing an income annuity:

  • Retirement Goals and Income Needs: Start by assessing your retirement goals and determining how much income you'll need to cover essential living expenses and maintain your desired lifestyle during retirement. An income annuity should complement your overall retirement plan and provide a reliable income stream.
  • Your age and health: The younger and healthier you are, the more likely you are to outlive your life expectancy and receive less income from your annuity. If you are in poor health, you may want to consider a deferred annuity that starts paying out income later in life, when you are more likely to need it.
  • Lump-Sum Amount: Decide how much money you are willing to invest in the income annuity. Keep in mind that once you invest the lump sum, you generally won't have access to that principal amount, so ensure you retain sufficient liquid assets for emergencies and unexpected expenses
  • Your risk tolerance: If you are risk-averse, an income annuity may be a good option for you. However, if you are willing to take on more risk, you may be able to earn a higher return on your money by investing in other assets.
  • Your tax situation: Even if you know what is an annuity and how this is txaed, make sure you understand the tax implications of purchasing an income annuity. Income annuities can be taxed in a variety of ways, so it is important to speak with a tax advisor to understand how an annuity will affect your taxes.
  • Inflation Protection: Consider whether the annuity offers inflation protection. Without it, the purchasing power of fixed payments may erode over time due to inflation. Inflation-adjusted annuities may provide more stable income over the long term.
  • The fees: Income annuities can have high fees, so it is important to shop around and compare different annuities before you make a purchase.

Income vs Other Types Of Annuities

Income annuities are one of the most popular types of annuities, but there are other types of annuities that may be a better fit for some people.

Here is a comparison of income annuities to some other types of annuities:

Type of Annuity
How it Works
Fixed Annuity
Guarantee you a fixed interest rate for a set period of time
Variable Annuity
Invest your money in a variety of mutual funds. The value will go up and down with the stock market
Indexed Annuity
Invest your money in a stock index, such as the S&P 500. The value will go up and down with the stock market
Immediate Annuity
You pay a lump sum of money and start getting an income stream immediately
Deferred Annuity
start getting an income stream at a later date, such as when you retire

The ideal annuity for your situation will hinge on your unique needs and objectives. If you seek a secure income stream that lasts a lifetime, an income annuity might suit you best.

On the other hand, if you're open to assuming some risk in pursuit of greater potential returns, a variable or indexed annuity could be a more suitable choice.

FAQs

For single-life annuities, the payments usually cease upon the annuitant's death. However, some annuities offer options to continue payments to beneficiaries for a specified period or provide a refund of the remaining principal.

Most income annuities have limited or no access to the principal before payout phase. It's essential to consider the liquidity needs before committing to an income annuity.

Fixed income annuities offer a predetermined payout, while variable income annuities tie the payout to the performance of underlying investments, allowing for the potential of higher returns but with more market risk.

Income annuities are typically inflexible once the contract is established. It's crucial to thoroughly review the terms and choose options that align with your long-term needs.

Income annuities are not FDIC insured. They are backed by the financial strength of the insurance company issuing the annuity.

In the current economic enviroment, inflation protection can be essential to maintain the purchasing power of your income over time. Consider options that include inflation-adjusted payments if you are concerned about rising living costs.

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Picture of Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
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