For some investors, an annuity can be an appropriate part of a sound financial plan. However, one feature of annuities that is commonly misunderstood is payout options. Here we define these options, how they are calculated and how they are taxed.
Phases of an Annuity
The two phases in the life of an annuity are the accumulation phase and the annuitization phase (or payout phase). During the accumulation phase, you can add funds to your annuity contract by depositing cash, converting life insurance cash values or doing a 1035 exchange from another annuity (to name a few ways of contributing). If you follow the annuity rules, your annuity will accumulate earnings on a tax-deferred basis until you make withdrawals.
Once you reach age 59.5, you can begin to withdraw funds from the annuity without penalty charges.
Annuity Payout Options
There are a few different methods for taking annuity payouts. Generally speaking, the two most common methods to receive cash payouts are the annuitization method and the systematic withdrawal schedule. The other is taking a lump-sum payment. The annuitization method gives you some guarantee of monthly income for a determined period. Under the systematic withdrawal schedule, you have complete control over the timing of distributions but no protection against outliving annuity assets.
Let's look at some different options you have with the annuitization method.
- Life Option
The life option typically provides the highest payout because the monthly payment is calculated only on the life of the annuitant. This option provides an income stream for life, which is an effective hedge against outliving your retirement income.
- Joint-Life Option
This common option allows you to continue the retirement income to your spouse upon your death. The monthly payment is lower than that of the life option because the calculation is based on the life expectancy of both the husband and wife.
- Period Certain
With this option the value of your annuity is paid out over a defined period of time of your choosing, such as 10, 15 or 20 years. Should you elect a 15-year period certain and die within the first 10 years, the contract is guaranteed to pay your beneficiary for the remaining five years.
- Life with Guaranteed Term
Many people like the idea of income for life (which they get with the life option), but they are afraid to choose that option in case they die in the near future. The life-with-guaranteed-term option gives you an income stream for life (like the life option), so it pays you for as long as you live. But with this option, you can select a guaranteed period, such as a 10-year guaranteed term, for which your annuity is obligated to pay to your estate or beneficiaries even if you die before that guaranteed period is over.
Systematic Withdrawal Schedule
Under this method, you can select the amount of payment that you wish to receive each month and how many you want to receive. However, the insurance company will not guarantee that you will not outlive your income payments. How much you receive and how many months you receive payments depends on how much you have in the account. The burden of life-expectancy risk is on your shoulders.
Taking out the assets in your annuity in one lump sum is usually not recommended because, in the year you take the lump sum, ordinary income taxes will be due on the entire investment-gain portion of your annuity. Clearly, this is a very inefficient payout option from a tax minimization perspective.
Electing Not to Take Payments
Some individuals have no need for income from the funds that have accumulated in their annuity. If the same is true for you, be sure to check your beneficiary designation is correct since the annuity can be transferred to your beneficiary at your death.
How Does the Insurance Company Compute your Monthly Payment?
There are several factors that insurance companies use to compute your monthly payment amount; two of the most common are gender and age - both of which affect your life expectancy. Since women have longer life expectancies than men, women won't receive as high of a payment as their male counterparts. And, of course, the older you are, the lower your life expectancy. A 75-year-old man with the life option will receive a higher monthly payout than a 65-year-old man because the older man's life expectancy is shorter.
Another major factor that affects the size of your monthly payout is the payout option that you select - which affects how long the payments will last. For example, if you select the joint-life option, your monthly payout most likely will be lower as the payment continues to your spouse after your death.
Finally, the size of your monthly payout depends also on the insurance company that you use, and its expected investment returns on your money. If the company can make a 5% instead of a 3% return with your money, your payment will be higher. However, the increase in your payment when returns are higher depends on whether you select a fixed monthly payout or a variable monthly payout from your annuity. If you select the fixed amount, your payout will not change, and the insurance company assumes all investment risk. Under the variable payout, the size of the monthly payout fluctuates based on market conditions, so you assume the market risk.
Tax Treatment of Annuity Payouts
Once your contract is annuitized, part of each payment (from a fixed annuity) is considered a partial return of the basis (your contribution) and part is taxable income using an exclusion ratio. Once you select your payout method with your insurance company, you should ask for your exclusion ratio, which tells you how much is excluded from being taxed. If your exclusion ratio is 80% on a $1,000 monthly payout, then $800 is excluded from income tax and $200 is subject to ordinary income tax.
Premature distributions (those occurring before you reach age 59.5) are subject to a 10% penalty, and for annuities purchased before Aug 14, 1982, the FIFO (first-in, first-out) method is used for withdrawals. For annuities purchased after Aug 13, 1982, the withdrawal rule is LIFO (last-in, first-out), meaning that earnings will come out first. You have to pay not only a 10% penalty on the withdrawal, but also income tax on any portion of the withdrawal attributable as investment gain. It is not a wise decision to pull funds prior to age 59.5, so try to avoid it at all costs.
Credit Quality Concerns
A final factor to consider is the credit quality of the insurance company. Remember that just because you have accumulated your annuity at one insurance company over the past 20 years, you don't necessarily need to start your payouts with them. If another insurer with a high rating has offered you a higher monthly payout, it might be worth your time to look into doing a tax-free 1035 exchange to the new insurer, but make sure to check the surrender charges on your current contract before you initiate any transfer! The insurance companies have well-paid employees in specialized departments that will provide you with an estimated payout for each option. Make them earn that extra 1.5% in fees that they charge annually to your contract - have multiple quality insurance companies give you a quote on the current value of your annuity with multiple payout options.
Deciding on the best annuitization payout method to choose for your annuity is not an easy decision. Consider your priorities, the amount you need each month and how long you think you will need these payments.