Income Annuities: What Are They And How Do They Work?

Imagine a retirement where you never worry about running out of money. No more fretting over market fluctuations or questioning if your savings will last.

Income annuities are often hailed as the solution to longevity risk — that is, the risk of outliving your money. They allow you to swap out a lump sum of your retirement savings in exchange for a regular stream of income from an insurance company, sort of like a self-funded pension plan.

An income annuity is a financial product designed to convert a lump sum of money into a guaranteed stream of payments, either now or in the future. Often purchased by retirees or those nearing retirement, it can replicate a steady paycheck, regardless of market fluctuations.

Income annuity payments can be structured in a few different ways:

Once you choose your income structure, the payout amount is determined based on multiple factors, including your age, the amount you invest and current interest rates (more on that later).

Your payout amount is locked in up front. Basically, you’re trading liquidity now for guaranteed income later. So once you sign the contract and fund the annuity, that money is no longer accessible as a lump sum.

How do income annuities work?

Income annuities typically don’t have ongoing fees like variable annuities, though the insurer builds their profit margin into the contract. So, there are no “explicit” fees, but be aware the quoted payouts reflect all built-in costs.

Income annuities work by converting a hefty up-front payment — or a series of payments — into a set of guaranteed income payouts. These payments can begin immediately or at a deferred date.

There are two main types of income annuities.

• Single-premium immediate annuity (SPIA): SPIAs are the most common type of income annuity. As the name suggests, these annuities start paying you almost right away — typically within 30 days to one year of purchase. You pay a single lump sum and get a fixed monthly payment for life or a set term.
• Deferred income annuity (DIA): With a deferred income annuity, payments start years down the road — such as 10 or 20 years from now. The longer payments are deferred, the bigger the future payout. Deferred income annuities (also called longevity annuities) are often used as a hedge against living a very long life. Someone in their early 60s might buy one that starts paying at age 80, locking in a future income stream if they live that long.

Pros and cons of income annuities

Income annuities, like most financial products, have their strengths and their drawbacks. While these contracts offer a way to replicate a paycheck in retirement, they come with restrictions you should be aware of before moving forward.

Pros

• Guaranteed income for life: Purchasing an annuity can provide peace of mind that you’ll have a steady stream of income, regardless of market fluctuations.
• Inflation protection: Some annuities offer cost-of-living adjustments, sometimes at an added cost, to help maintain purchasing power.
• Tax benefits: Earnings within the annuity grow tax-deferred.

Cons

• Loss of control: Once you invest in an income annuity, you generally cannot access the principal amount. It can be difficult — and costly — to get money out of an annuity, especially once you begin receiving payments from the insurer.
• Limited growth potential: Since annuity payouts can be tied to a fixed interest rate, payouts may not keep pace with inflation over time.
• Fees and surrender charges: Be wary of potential fees associated with annuity purchases and early withdrawals. Surrender charges and riders can eat into your returns.

How much money can you receive with an income annuity?

The size of the payouts you can expect from an income annuity depends on your age, your initial investment amount and current interest rates.

First, the larger your initial investment, the higher your monthly payout will be. You’ll generally need to commit $100,000 or more to generate any kind of meaningful payout in retirement. Higher interest rates also generally translate into higher annuity payouts.

Meanwhile, younger individuals typically receive lower payouts due to their longer life expectancy. The specific income option you choose (lifetime, period certain or joint-survivor) will also impact your payout amount. For example, the joint-survivor option will always result in lower payouts, since payments need to last the life of two people instead of one.

Online annuity calculators can help estimate potential payouts based on your specific circumstances. However, it’s always smart to consult with a financial advisor to determine the most suitable option for your retirement goals.

Who is a good fit for an income annuity?

If you’re risk-averse with a low tolerance for market fluctuations, income annuities can provide a guaranteed income stream while shielding you from the turbulence of the stock market. They can also be a suitable option if a long life expectancy runs in your family and you expect to live a long time in retirement.

However, it’s essential to weigh the potential drawbacks before committing to an income annuity. Accessing the principal amount is usually restricted and often comes with high surrender charges. This gives you less liquidity compared to other investment options such as stocks and bonds, which can easily be bought and sold during regular trading hours.

If you’re interested in purchasing an annuity, financial experts generally recommend allocating a portion — but not all — of your retirement savings to the annuity. A good rule of thumb might be 10-20 percent of your retirement nest egg. This ensures you remain diversified with multiple income streams that include Social Security and 401(k) savings, as well as annuity payouts.

Income annuity FAQs

• Are income annuities safe?
  

  Income annuities are generally considered a low-risk investment since they’re backed by the issuing insurance company. However, it’s important to choose a reputable annuity company with strong financial standing. There are also fees and penalties associated with some annuities that might not make them suitable for everyone.

• Can I withdraw money from an annuity?
  

  With an income annuity, accessing the principal amount typically comes with surrender charges, which can be significant. Deferred income annuities may offer more flexibility for withdrawals before the income stream begins.

• What happens to my annuity if I die?
  

  The payout option you choose will determine what happens to the remaining funds in your annuity after you pass away. You may be able to name a beneficiary to your contract, at an additional cost. Otherwise, your remaining balance may go to the insurance company after you die.

• Are there tax implications with annuities?
  

  Earnings within the annuity grow tax-deferred. However, you will pay taxes on a portion of the payouts you receive. This portion is typically taxed as ordinary income. There may also be tax penalties for early withdrawals.

Bottom line

Income annuities offer a way to secure a guaranteed income stream in retirement. However, they’re not a one-size-fits-all solution. Carefully consider your retirement goals, risk tolerance and income needs before investing in an annuity. Consulting with a qualified financial advisor can help you determine if an income annuity is the right fit for your financial situation.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.