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Immediate Annuities Explained

An immediate annuity is a financial instrument sold by insurance companies that allows the buyer of the annuity to generate a stream of income after making a one-time premium payment. The term "immediate" refers to the fact that the stream of income starts after a very short period of time. It differs from a deferred annuity, where the annuitant may have to wait 10 years or longer before he or she starts to receive a monthly payout.

Generally, immediate annuities are set up to start the payout in approximately 30 days, or the month after the contract was signed. When you buy an immediate annuity, you turn over a lump sum of money to the insurance company and the insurance company guarantees to pay you a fixed monthly or periodic payment for a set period of time or for the rest of your life. In return for the guarantee of income for life, you give up all rights to the premium you paid to buy the annuity.

How much will your monthly payout be?

Your monthly payout is based on a variety of factors including your life expectancy. For a life income option, after considering several factors including your age, gender and prevailing interest rates, the insurance company will calculate a monthly payout amount. You are guaranteed to receive that payout for the rest of your life, no matter how long you may live.

If you buy a $100,000 immediate annuity and are only expected to live 10 years, the monthly payout will be higher than if you purchased that same annuity and were expected to live 20 more years. The exact amount you will be paid each month also depends upon the prevailing interest rates at the time you purchase the annuity.

Making an educated guess

Insurance companies use actuarial charts and mortality tables to make an educated guess about how long a person will live. Under a life income option, the total amount of your payout depends on how long you live. The longer you live, the higher the total payout. If a life income option is selected, the immediate annuity will pay you a regular stream of income up until the day you die. After that, two things can happen.

If you purchased a “life only” immediate annuity, your death ends the contract. For example, if you only lived long enough to collect 50 percent of the amount you paid to purchase the annuity, the insurance company is not obligated to return any money to your beneficiaries. On the other hand, if you live beyond your life expectancy the insurance company is obligated by contract to continue your payments as long as you live.

If, however, you purchase a single premium immediate annuity called a “life plus five or ten years” and you die a year after the purchase, the life insurance company must continue to make monthly payments to your beneficiaries. If you chose "life plus ten," your beneficiaries would receive monthly payments for the next nine years. This will reduce the monthly periodic payouts but in the event of an untimely death shortly after taking out the contract, the beneficiaries will receive the ongoing stream of payouts or a lump sum payment depending upon how the contract is structured.

Tax-advantaged income

For nonqualified money, the IRS considers a portion of each monthly payment to be a return of principal and therefore when you make a withdrawal only the portion that is considered interest earned is taxed at your current income-tax rate.

For qualified money, you benefit because you are able to defer taxes on your money until it is time to start taking withdrawals. The entire distribution is taxed (at your current income-tax rate) at the time of the withdrawal.

Funding immediate annuities

You can buy an immediate annuity by using funds from any number of different sources. You can use money from a retirement plan, from the proceeds of the sale of a home, from selling stocks, or you can simply write a check from your savings account.

Immediate annuities may be appropriate for people looking to establish a guaranteed monthly income for life. People who have no beneficiaries may also be good candidates for this type of annuity. Immediate annuities can also be an excellent choice when current interest rates are high because you can get a higher monthly payout.

Buying an immediate annuity

There are many different insurance companies that sell immediate annuities and it can be very difficult to determine which one you should buy. If you are considering any annuity product, it is always best to seek the assistance of an independent agent who is familiar with all types of annuities and the contracts and riders available in your state.