Defined-income annuities have fixed income terms, making them useful for financing early retirement or upfront financing a loan or large life insurance policy.
Direct income annuities with a lifetime benefit are popular for a reason. By providing immediate monthly income that is guaranteed for life, they help ensure a worry-free retirement.
But you don’t have to choose the lifetime option. Instead, you can choose a fixed income term, from five to 20 years. Sometimes it makes perfect sense to opt for an annuity with a certain income.
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For example, you may need additional income to fund early retirement until Social Security and/or a company pension takes effect. Or you may want to delay using Social Security until age 70 to maximize your income benefits. Or maybe you want to prepay a loan or a large life insurance policy that has to be paid in installments over a period of time.
Period-determined income Annuities provide a high guaranteed income
An immediate annuity (opens in new tab) is purchased with a lump sum, which is why it is called a single premium immediate annuity (SPIA). Whether lifetime or period-secure, it usually has no cash surrender value after purchase. You transferred your money to an insurance company in exchange for a guaranteed income.
With a Lifetime Income SPIA, an optional cash back feature ensures that your premium payment is not lost in the event of an early death. If you die before your monthly income payments equal the full single payment of your annuity, your beneficiary gets the difference.
You can also choose to add your spouse, so that he or she will continue to receive income after your death, assuming you die earlier. This option usually lowers your payments slightly.
With a term annuity, depending on your age at issue and the selected payment term, you usually get larger monthly payments than with a lifetime variety, because the insurance guarantees income for a certain period of time, not for your life. The shorter the period, the higher the annual or monthly income.
You get a much higher guaranteed income than with other alternatives. Part of the reason is that with a given annuity, if unqualified, most of the income you receive is a tax-free return of your principal, and the rest is taxable interest. (When the annuity is held in a qualified retirement plan, such as a traditional IRA or a 401(k), payments are fully taxable.) For example, bank certificates of deposit do not provide comparable income because you can only take interest unless you are willing to make a significant fine to the bank. Otherwise, you’ll have to wait until the due date to get your principal back.
The other reason annuities bring in more income is that they usually pay significantly higher underlying interest rates than bond funds, CDs, and money market accounts.
Moreover, you will not get any similar guarantees. Money market rates fluctuate; bond fund prices vary.
Let’s look at some possible applications.
Income for early retirement
Say you want to retire now, but put off taking Social Security for eight years. You can buy an eight-year annuity to fill your income gap.
Here’s an example. Joe, age 60, retires and invests $200,000 over eight years with a sure immediate annuity and lists his wife as a co-annuitant so she is protected and continues to receive any remaining payments if he dies before the eight years be over. This form of annuity allows him to accurately calculate his annual return.
Joe receives $2,471.21 per month, including $2,083.33 in principal and $387.88 in taxable interest. After eight years, he starts collecting Social Security and doesn’t need the extra income.
Pre-finance installment payments for a large life insurance policy or loan
Suppose you decide to take out a large life insurance policy. Instead of financing the policy with a single premium payment, you can purchase a 10-year annuity with annual payments that you use to make the premium payments over time. This prevents the life insurance from being classified as an amended capital contract (MEC), which can be tax detrimental.
Or suppose you have a substantial loan with a prepayment penalty. Instead of paying off the loan and taking the down payment, you can purchase a certain annuity to pay off the remaining payments in advance.
Here’s an interesting income strategy that combines two types of annuities.
Say you have $100,000 to deposit and your combined federal/state tax bracket is 28%. How can you maximize your guaranteed after-tax income?
You can simply buy an annuity with a fixed-rate term of 10 years (opens in new tab) yield 5.20%. A fixed-rate annuity is much like a bank CD: You deposit a lump sum and the insurer agrees to pay a fixed guaranteed interest rate for the term.
You can then withdraw $5,200 in interest annually. These withdrawals are fully taxable, resulting in $1,456 in additional taxes, giving you a net after-tax income of $3,744.
Here’s an alternative. Instead, you would put $60,234 into the fixed-rate annuity and the balance, $39,766, into a 10-year period with an immediate annuity that pays an annual income of $5,010. Of that amount, $1,032 is taxable and $3,978 is non-taxable
The $60,234 allocated to the fixed-rate annuity is deferred for tax purposes so that it equals your original $100,000 at the end of 10 years.
On the face of it, putting all the money into a fixed-rate annuity would seem to generate more income than the split-annuity strategy. However, with the split strategy, only $1,032 of the annual income payment is taxable because the remainder of the payment is a return of your premium deposit. As a result, only $289 in annual taxes is due, leaving net after-tax income of $4,721, which is $977 more than if you put all the money into a fixed-rate annuity.
In retirement, most people rely on a combination of Social Security, retirement plans, and personal savings for income. A split annuity strategy can help replenish those resources, add stability, and keep you from outliving your assets.
The vast majority of instant annuities purchased include some sort of lifetime payout setup. But they are not the only good income solution. Review your situation and talk to an experienced annuity advisor. It may be that a certain annuity fills the account.
This article is written by and represents the views of our contributing advisor, not the Kiplinger editors. You can check advisor records with the SEC (opens in new tab) or with FINRA (opens in new tab) .
