Retirement planning involves an almost overwhelming number of decisions, including choosing the correct mix of products and strategies to help you achieve your financial objectives. One potential approach to income planning for retirement is annuitization. Annuitization enables a retiree to add a reliable stream of income in retirement via an annuity contract. Annuitization offers long-term peace of mind, but it’s essential to understand both the benefits and the limitations before making a decision.
What is annuitization, anyway?
Essentially, annuitization is the point at which you decide to convert your annuity investment into guaranteed income payments. Some financial experts say annuitization is literally a point of no return, which is why it is so critical that you understand all your choices and their implications.
As the name implies, annuitization begins with an annuity. You probably already know that an annuity is a contract where an insurer gives you a guaranteed income in exchange for your lump sum (or series of payments.) Depending on the type of annuity, payouts from your annuity either begin immediately or after a period of potential growth — sometime in the future. Many people report greater peace of mind in retirement, knowing they have at least one other source of guaranteed income besides Social Security. An annuity is, in some ways, like having your own private pension.
Not all annuities are the same, however. There are differences in their fundamental structures and also in the ways in which they may provide growth and tax benefits. There are also differences in how certain annuities can be annuitized. For instance, single premium immediate annuities or SPIAs and deferred income annuities (DIAs) don’t really have a conversion after investment. That’s because you establish the guaranteed income streams at the time of purchase.
Other types of annuities offer the flexibility to choose between a variety of payout periods, such as a set number of years or your lifetime. If you want or need to ensure financial support for a loved one, for instance, a spouse or a special needs child—a joint life or period certain annuity might be a helpful option. These types of annuities continue payouts after the primary annuitant passes away.
As mentioned earlier, you can purchase an annuity with either a single lump-sum payment or a series of contributions, and these funds will grow over time based on the type of annuity selected. Once you decide to annuitize, the insurance company calculates your life expectancy, the value of the annuity, and your payout preferences to determine the amount of your payments.
How can annuitization benefit me?
Annuitization has numerous advantages, especially for people who want more security and predictability when the time comes to stop working.
Annuitization creates guaranteed income for life: Of all the financial vehicles available in the 21st Century, only an annuity gives you guaranteed income that you won’t outlive. Income for life is one of the most attractive aspects of annuitization. Seniors often cite the lifetime income benefit as their primary reason for choosing an annuity over other safe money products. An annuity’s consistent, predictable payouts can act as a hedge against outliving your savings, providing peace of mind during the retirement years.
With annuitization, you can have earnings beyond the purchase price: Even if your total payments exceed the amount you initially contributed, plus any investment growth, annuity income continues as long as you live. One of the reasons annuities are classified as insurance products is this protection against outliving your savings, also known as “longevity risk.”
Annuitization is “set and forget”: Once you decide to annuitize, your income stream is automatic. There’s no need to actively manage the investment, which is especially appealing for retirees who don’t have the time, patience, or skills necessary to actively manage their investments.
Possible pitfalls of annuitization.
Annuitization has many benefits. But like all financial products, it has a few potential downsides you should consider.
Your payments may end at death: In some instances, payments stop when the annuitant dies. This means there are no remaining funds for beneficiaries. If you have a spouse or other loved one for whom you’d like to leave a legacy, you might want to opt for joint or period certain payouts.
You lose some liquidity: Once you’ve chosen to annuitize, you’ve locked your money into a payout plan. You can’t withdraw the principal as cash or access the remaining balance early.
There may be fees and tax considerations. Certain annuity contracts come with significant costs that can reduce the overall return on your investment. Additionally, while non-qualified annuities provide tax-deferred growth, the income you receive when you annuitze is taxed as ordinary income rather than at the lower capital gains rate.
How does annuitization work in real life?
Example 1: A single retiree who wants income for life.
Belinda is a single retiree with no children. She values simplicity and wants to ensure she has a steady income for as long as she lives. Belinda decides she wants a life-only annuity, which provides her the maximum monthly income because it’s based entirely on her life expectancy. While there’s no provision for beneficiaries, Belinda feels confident that her other assets will cover any final expenses.
Example 2: A couple planning for both their futures.
Marie and John are a couple in their late 60s. Since John is the primary breadwinner, the couple is concerned about Marie’s financial security if John passes away first. They decide on a joint life annuity with a 50% survivor option. This option ensures that when John dies, Marie will continue to get half of the original payment amount for the rest of her life. The joint life option means they are not sacrificing too much in monthly income to gain some financial peace.
How does taxation impact annuitization decisions?
As pointed out earlier, annuities can either be qualified or non-qualified. Whether your annuity is qualified or non-qualified determines how they are taxed:
There are “non-qualified” annuities: Funded with after-tax dollars, non-qualified annuities grow tax-deferred. Once you begin annuitization, part of each payment is treated as a return of your original investment, meaning that portion is not taxed. The remainder of the payment is taxable as ordinary income.
“Qualified” annuities are taxed as ordinary income: Typically part of an IRA or employer-sponsored retirement plan, qualified annuities are funded with pre-tax dollars. As a result, the IRS taxes all annuitization payments as ordinary income. Those with Roth IRA annuities make contributions with after-tax money. Qualified distributions from a Roth IRA annuity are tax-free.
Summing it up: Should you consider annuitization as part of your retirement plan?
Annuitization is a powerful tool for creating a stable, predictable income stream during retirement. But it’s not a one-size-fits-all solution. Because annuities can be complex and come with long-term commitments, it’s essential to weigh the benefits against the limitations and consider your personal financial goals. Talk to a qualified annuity specialist to determine if annuitization is the right choice for you and, if so, how it can fit into your broader retirement plan.
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