Key Takeaways
- An income annuity converts your premium payments into a steady stream of income.
- Instead of providing a fixed rate of return, an income annuity provides a fixed monthly income that is guaranteed for life.
- Lifetime income annuities can provide a hedge against outliving your savings.
- Income annuities may include penalties and surrender charges if you withdraw payments too soon.
Income annuities are uniquely designed to generate a stream of income in exchange for one or more premium payments. The payments from an income annuity may be received monthly, quarterly or annually depending on your preference.
Unlike other types of annuities, income annuities are annuitized immediately, regardless of when your payments actually begin. This differentiates them from accumulation annuities, which some people never annuitize.
How Do Income Annuities Work?
An income annuity works by converting a large sum of cash into a stream of regular payments. You give the money to an insurance company, and in exchange, the insurer agrees to pay you for a certain length of time — or for the rest of your life.
You may receive your annuity payouts monthly, quarterly or yearly, depending on your contract.
Because your regular payouts from the insurance company begin within a year, income annuities are often called immediate annuities.
Other names for income annuities include:
- Immediate annuity
- Single premium immediate annuity (SPIA)
- Deferred income annuity (DIA)
- Payout annuity
Keep in mind that income annuities are intended to provide guaranteed income, not help you accumulate retirement savings.
Unlike other types of annuities, income annuities are annuitized immediately, regardless of when your payments actually begin. This differentiates them from accumulation annuities, which some people never annuitize.
Finally, all annuities are tax-deferred — which means you won’t owe taxes until you start receiving payments. Money is taxed as ordinary income when it’s withdrawn or distributed.
Annuity contracts are legal documents. If you have questions about the terms of your contract, make sure you get answers before you sign. Ask about commissions and fees, surrender charges and the free-look period.
Use the Financial Industry Regulatory Authority’s free background-research tool to find a financial professional.
If you need assistance with any aspect of your retirement planning, talk to a credible financial advisor.
When Do Income Annuity Benefits Typically Begin?
One of the most attractive features of income annuities is their ability to provide guaranteed income in retirement.
You can customize your annuity contract so that income payments begin right away or at a later date. According to FINRA, the annuity is known as a deferred income annuity if the payout is set to begin at a predetermined future date.
- Immediate
- Your income payments will begin within a year of purchasing the annuity.
- Deferred
- Your income payments will begin at least one year after your purchase.
Immediate and Deferred Annuities
Deferred income annuities may be a better option if retirement is still a few years away or you don’t need income right now.
Read More: What Is a Fixed Annuity?
What Are the Pros and Cons of Income Annuities?
The biggest benefit of income annuities — specifically lifetime income annuities — is insurance against outliving your retirement savings. In other words, the insurance company is on the hook for your payments — even if you draw down your account to zero.
Pros of Income Annuities
- Protection from outliving your savings (risk protection)
- Customizable contract details
- Tax-deferred growth
- Payment from your contact lasts even after you’ve recovered your principal and all your earnings
- Fluctuations in the stock market have no effect on income payments
One disadvantage of income annuities is they typically pay a fixed amount of income. Over time, inflation may eat away at the value of your payouts.
Some insurers offer optional riders that increase your income payments to help keep pace with inflation. However, this perk comes at an extra cost.
Cons of Income Annuities
- May not provide money for your heirs
- Funds are not easily convertible into cash
- Penalties and surrender charges may apply upon withdrawals too much, too soon
Read More: What Is a Fixed Index Annuity?
Peace of Mind Comes From Knowing Your Money Is Protected
How Much Money Can You Expect to Receive with an Income Annuity?
An income annuity doesn’t provide a fixed rate of return, like a certificate of deposit (CD). Instead, you receive a fixed monthly income guaranteed for life, no matter how the markets perform.
How much money you receive from your income annuity is tied to how much money you put in along with your life expectancy at the time payouts begin.
The total payout from your annuity depends on how long you live. The longer you live, the more total income you’ll receive.
You will receive larger monthly payments if you structure payouts to only last your lifetime. If you die prematurely, the rest of your money stays with the insurance company.
However, for a slightly lower monthly payment, you can structure your income annuity to provide payouts to both you and your spouse, or to another beneficiary after you die.
Longevity Risk Protection
Insurance companies can provide longevity insurance thanks to “mortality credits” — a unique characteristic of lifetime income annuities.
Here’s how mortality credits work: When you buy an income annuity, the insurance company adds your premium to the pool of premiums it has collected from other annuity owners. The insurance company bases lifetime income annuity payments, in part, on the average life expectancy of the annuitants in the pool.
Some annuity owners will live longer than the number of years expected, but some will die earlier, leaving behind their share of income payments. These remaining payments are the mortality credits, and they are distributed to the surviving annuity holders from the pool.
If you die before you receive all your income annuity payments and you haven’t purchased a rider to allow for beneficiaries, then your remaining payments will go to annuitants who live beyond their life expectancy.
Read More: What Is a Variable Annuity?
What Is the Difference Between a Deferred Income Annuity and a Deferred Annuity?
Both single premium immediate annuities (SPIAs) and deferred income annuities (DIAs) are annuitized immediately. This means that your premium is converted to a stream of payments right away.
SPIAs are annuitized immediately and begin paying income within a few months while DIAs begin payout later.
SPIAs are straightforward, but people often confuse DIAs with deferred annuities. A deferred annuity doesn’t convert your premium to an income stream until the annuitization date specified in your contract.
To avoid confusion, think of a DIA as an immediate annuity with a delayed start date.
Deferred Income Annuity (DIA)
- Premium is immediately converted to a series of payments.
- Income benefits are delayed.
- Interest is fixed.
Annuity expert Dr. Wade Pfau clarifies the difference in his book “Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement.” Dr. Pfau explains that the word “deferred” in a deferred income annuity refers to the postponement of the income payments, not the process of annuitization.
A deferred annuity, on the other hand, uses the word “deferred” to describe the delay in converting the contract value into a guaranteed stream of payments. Deferred annuities are not immediately annuitized and are often used for wealth accumulation as opposed to retirement income.
Deferred Annuity
- Contract value is converted to a series of payments if and when you choose to annuitize.
- Income may be immediate if you add a lifetime income benefit rider to your annuity contract.
- Interest can be fixed, indexed or variable.
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Frequently Asked Questions
Income annuities can be qualified or nonqualified. If you purchase an income annuity with pre-tax dollars from a qualified retirement plan, the annuity is considered a qualified annuity. If you buy the annuity with after-tax dollars, it’s a nonqualified annuity.
If you did not purchase a rider with your income annuity, the insurance company will distribute your remaining account balance as mortality credits to surviving annuitants from the general account pool.
You will benefit from an income annuity if you are in good health and your family history suggests you will live beyond the average life expectancy.
Income annuities are tax-deferred. Money is taxed as ordinary income when withdrawn or distributed.
Income annuities are immediate annuities, meaning the premiums are immediately converted to a series of income payments. Single premium immediate annuities (SPIAs) and deferred income annuities (DIAs) are the two types of income annuities and may also be referred to as longevity insurance or payout annuities.
