Immediate Annuities
It’s possible to get a high fixed return on your money
with an immediate annuity to provide retirement income. An immediate annuity is simply the payment of a premium
to an insurance company. In exchange, the company converts your premium to
a monthly income for life. You cannot outlive this retirement lifetime income! (Monthly payments
are based on the claims-paying ability of the insurer, so picking a financially
solid insurance company is important.)
Here’s a hypothetical example. A 76-year-old gentleman
paid $50,000 in premium to an insurance company. He now receives $388 retirement income per
month, every month. That’s $4,656 each year of checks in the mail. For $50,000
where else can you get guaranteed $4,656 every year for the rest of your life?
Regardless of how long he lives, he gets his check
every month. If he dies early, his beneficiaries will receive the $388 monthly
until $50,000 in payments have been received in total. This is called the “installment
fund” provision. (If the owner does not need or does not elect the installment
refund provision for his beneficiaries, the monthly payments would be even
higher at $473 per month.)
For whom is an immediate annuity suitable?
- A retiree needing increased monthly retirement income
- A person with no heirs or who is not concerned about
leaving an estate
- Someone who has set aside other funds to leave to heirs
if they desire to leave an inheritance
- A retiree desiring the fixed payment and wanting to
avoid maturities, rolling over investments and the maintenance and administration
required of investing on one’s own
Your
immediate annuity may give you a double tax break
If you’re concerned
about having enough income to last and you want to maximize it – perhaps
an immediate annuity is for you. You’d ensure an income for life but it’d
depend on your age and sex. When you die, that’s it – your investment is
gone. But this may be fine in your case and in other cases rules out the
use of immediate annuities.
What are the
tax consequences?
The money in
your immediate annuity will grow at a fixed rate while you take your payouts.
Each payout has both a taxed and untaxed portion. The untaxed part is your
basis –i.e. your purchase price. Its fraction of each payout - called the
exclusion ratio - remains fixed at the ratio of your purchase price to the
expected total payout based on your remaining life expectancy.
For illustration purposes, we’ll estimate the total payout for 15 years for
a 65 year old male living in California who invests $100,000 - based on a leading
supplier of immediate annuity quotations . Fifteen years is the IRS table’s
expected life at of a 65 year old man. Their estimate gives $675/month – with
no beneficiary (lower payouts would include guaranteed term payouts to beneficiaries).
The total payout over 15 years at $675/month is $121,500. So the exclusion
ratio is 82.3% (= $100,000/$121,500)!
So, your annual
income from your $100,000 immediate annuity investment is $8,100 of which
only $1,434 is taxable. At a 25% marginal tax rate, you net about $7,700
per year. Not a bad cash flow!
If you had invested
your $100,000 in 10 to 30 year corporate bonds at the prevailing 5% rate,
you’d generate a $5,000 yearly income but all of it taxable. Again at a 25%
marginal tax rate, your net income is $3,750 – about half as much as you
net from your immediate annuity.
Purchasing tax
free bonds – at a lower prevailing interest rate- may give you more net income,
but still significantly less cash flow than from your immediate annuity.
Further possible
tax savings on taxable social security
Social security
becomes subject to tax for provisional incomes beyond $25,000 for single
individuals, and $32,000 for married filing jointly. It can be taxed up to
85% beyond the $34,000 and $44,000 thresholds respectively. This provisional
income includes all taxable income, 50% of your social security income, and
tax free bond income.
Your immediate
annuity income adds only $1,434 to your provisional income compared to $5,000
from 5% tax free bonds or corporate bonds. If you’re near or within the above
threshold levels, you’ll reap additional tax savings from social security
income that remains untaxed due to your immediate annuity’s lower contribution
to provisional income. That tax savings can be substantial too.
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