Retirement Income Blog

One of the advantages of immediate fixed annuities is the feature that provides you with income for the rest of your life, for both you and your spouse, or simply to pay you for a fixed number of years. But what’s the best choice for you? Let’s consider some payouts based on annuity type and other factors to get a feel for what to potentially expect.

We’ll hypothetically assume a man has $50,000 to invest in an annuity. He’s 70 years old with a remaining average life expectancy of 16 years. What kind of payouts can he expect to get?

If he wants an immediate fixed life annuity on himself, a hypothetical insurance company  determines a monthly payout for him based on his sex, age, investment amount, and the current interest rate. The current interest rate is particularly important since their profit will be based on how much they’ll get for investing his $50,000. They’re predicting the man will die 16 years later (at least that’s their bet based on the average life expectancy of males age 70) so they know how many monthly payments they must make. They’re obliged to keep paying if the man lives longer, but also get to keep the investment if the he dies earlier than expected.

Life Expectancy
In our hypothetical case, the monthly payout is $385.  Incidentally, if the man were 80 years old his remaining life expectancy would be 11 years. So the insurance company would pay out $554 per month since they’ll be statistically paying for fewer months.

Gender
Women statistically live longer than men. A 70 year old woman has a remaining life expectancy of 20 years. This implies more monthly payouts by the insurance company so her payout is only $352 for that $50,000 investment. And if she were 80 years old, her monthly payout would be $498 – somewhat less that then 80 year old man’s, because of her still longer life expectancy.

Joint Life
A married couple may opt for a joint life annuity where payments will continue until the second spouse dies. In the case that both are 70 years old, the insurance company would pay $318 since statistically it turns out that between the two, the survivor would statistically live longer. The payout remains the same even if only one remains alive 

Finally, if the single 70 year old man chose an annuity for a certain period – 10 years – under the prevailing rates, he’d receive $515. But in this case, the insurance company would pay his beneficiary the remaining payments if he died. The payout is the same for the women since there’s no age or age-related sex difference issue here.

For the most current rates, use the immediate annuity calculator.

Immediate fixed annuities are the payment of a single premium to an insurance company in return for periodic payments over a specific period or life.  Once payments begin, the annuity cannot be surrendered for value (there are a few companies that do allow commutation–the surrender of the annuity for a discounted refund).  Income from annuitization is taxed part as ordinary income and part as return of capital and a 10% penalty could apply if the recipient is under age 59 1/2. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. For other ways to generate income in retirement, visit the retirement planning center.

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While tax-free bonds can be a popular source of tax-free income, some retirees are not aware that they can receive a potentially higher source of cash flow from insurance companies using an immediate fixed annuity.

In exchange for the premium payment, the insurance company pays the annuity owner a cash payment for life or for a term of years. Each of these payments is comprised of interest and principal as determined by an actuarial calculation set forth in Section 72 of the federal tax code. The principal portion is not subject to income taxation. Once the owner has recovered his or her investment, the remaining payments will be taxed as ordinary income.|

Let’s take a look at the hypothetical case of Mr. Jones, age 70 with a $500,000 portfolio of municipal bonds, earning 4.17% tax free. He receives $20,850 of annual tax free income (4.17% x $500,000).

He decides to cash in his tax-free bonds and pay a premium to an insurance company of $500,000 for an immediate fixed annuity. With the immediate annuity, his yearly cash payment from the annuity would be $48,000 per year of which 65% is tax free (the tax free portion of an immediate annuity is the part the IRS considers return of your principal and is based on your life expectancy and the expected return). After taxes, he will have $43,800 to spend. His spendable cash increases by $22,950 annually ($43,800-20,850) over the tax free bonds.

You can see how much you could obtain form an immediate fixed annuity using the immediate annuity calculator.

So in this particular example, the yearly cash flow has increased by using the fixed immediate annuity. Of course, your results will vary based (among other things) upon your age, health, and premium payment. The payments in the example shown above are calculated on the life expectancy of the annuitant and the spot interest rates effective for the month of purchase under the contract. The spot interest rates can vary from month to month. The payments shown above are not subject to mortality fees, administrative charges, or other expenses. However, actuarial calculations, life expectancy assumptions, and interests rates can vary from insurer to insurer. Therefore, your results will likely vary from the examples shown above.

An immediate fixed annuity will usually not leave anything for your heirs unless you purchase from a company that offers a refund feature. This refund feature will typically reduce the size of the monthly annuity payments. The amount of the refund could also be reduced by surrender charges in some cases. Therefore, the fixed immediate annuity is generally better suited for people who place more importance upon increasing lifetime cash flow rather than leaving an estate to heirs.

Of course, an immediate fixed annuity or tax free bonds would only be a portion of a retirement portfolio and resources in the retiremenmt planning center can help you plan your entire portfolio.

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Although there are several flavors of annuities, the term “retirement annuity” typically refers to an annuity taken from an employer pension plan (e.g. monthly payments for life) or a non-qualified annuity purchased by an investor with after tax funds in return for monthly payments from an insurance company.  Retirement annuity rates or monthly payments will depend on the amount you invest, your age and the term you select for payments (you can generally select payments over 5 years or lifetime).  If you select lifetime payments, both you and the insurance company share risk on your life expectancy.  If you get hit by a bus and killed tomorrow, payments stop, they keep all your money and they win.  If you live to age 110, you get a great retirement annuity rate and they will be sorry to have you as a client they must pay for life.

A retirement annuity provides dependable security–think of it like another social security check but likely better.  While the Social Security system is upside down (has more payments due than it will have assets), commercial insurance companies invest and preserve your money to pay your claim.

To purchase a retirement annuity from an insurance company, you make a one-time payment and distributions typically begin within a month. A retirement annuity can be fixed or variable–your payment can be the same every month, you can opt for smaller payments in the beginning that grow over time (i.e. inflation adjusted) or you can have your payments based on a menu of investment options and you take the risk of how well the investments perform.  In  the case of the variable annuity, retirement annuity rates cannot be forecasted although some annuity companies will provide a minimum guaranteed rate of return.

In the case of he income payments you receive from a “fixed” retirement annuity, these will never change and are based on the amount you deposit, the age when you start and the interest rate environment at the time of purchase.

You can check retirement annuity rates with the immediate annuity calculator.  For an even more current quotation, ask your retirement consultant to get quotes from a number of insurance companies.

Note that the quotes you receive will show the monthly payment you get.  You will likely not see any interest rate on these quotes because the total payments to you may be unknown in the case of a life annuity, i.e. no one knows how much you will receive.  But if you died at your life expectancy, you could calculate the retirement annuity rate and get an internal rate of return about 2%.  You may be surprised why anyone would buy a retirement annuity at such a low rate.  It’s because of the security involved–no matter how long you live, you cannot outlive the funds on a lifetime retirement annuity.  The insurance company takes a substantial risk and provides a relatively low rate when priced to life expectancy.

If you are age 70 or above, you will likely not find a source of cash flow larger or safer than what you can obtain from the retirement annuity, with the comfort of knowing your payments are quite secure from a AAA rated insurance company. Even though the retirement annuity rate may be low (because your principal is never recovered), the monthly payments cannot be matched by an alternative with the same degree of safety.

Additionally, under current tax law, a portion of each payment received from a retirement annuity is tax-free until your total premium is recovered. The remainder of each payment is taxed as ordinary income in the year received.

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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 while reducing taxes – 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 if you desire to maximize your cash flow.

How does the immediate annuity help reduce tax?
Each payment from an immediate has both a taxed and untaxed portion.  This is due to an IRS rule that may make no logical sense but it helps seniors interested in reducing taxes. 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.  This part of the annuity payment is not taxed over term of the annuity.

To illustrate the power of reducing taxes, 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’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)!  Therefore, of each payment received 82% is not subject to tax for the next 15 years and this makes immediate annuities a powerful choice for reducing taxes.

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.

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 annuity.  So a large part of your increased cash flow comes from reducing taxes using the exclusion ratio that IRS provides for an immediate annuity.

Purchasing tax free bonds – at a lower prevailing interest rate- may give you more net income, but still significantly less than from an immediate annuity.  Additionally, taxfree bonds will not provide the tax reducton feature described below.

Further possible tax reductions 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. Reducing taxes on social secuity income is an obvious desire of most seniors.

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 annuity’s lower contribution to provisional income. Reducing taxes in this manner could be an additional $1,000 annually to spend.

Note that if select lifetime payments for your immediate annuity and live beyond your life expectancy, reducing taxes with your immediate annuity no longer works as all payments become taxable.  However, most immediate annuity owners are happy to live beyond their life expectancy to give up tax reduction.

You can learn  more about retirement annuities and tax planning for retirees at our main web site.

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This post provided by Javelin Marketing

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