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What Is a Guaranteed Lifetime Annuity?


Ensuring that you have enough income to cover your living expenses and support your lifestyle is one of the central financial challenges of retirement planning. Guaranteed lifetime annuities are designed to help retirees do just that, providing a stream of guaranteed income for life. However, like all investment products, they come with their own set of advantages and disadvantages. A financial advisor can help you determine whether a guaranteed lifetime annuity might fit your financial needs in retirement.

How Guaranteed Lifetime Annuities Work

Guaranteed lifetime annuities are contracts typically offered by insurance companies. They work on a simple principle: You pay a lump sum upfront or make regular payments over a period. In return, you receive a regular income for the rest of your life. This income can start immediately or at a predetermined future date.

Guaranteed lifetime annuities can offer a level of financial security that is particularly appealing to retirees concerned about outliving their savings. With this type of insurance product, there is no need to worry about market fluctuations or investment risks. The income payments are stable and predictable, making it easier for retirees to budget and plan for their expenses.

The money you use to purchase the annuity grows tax-deferred, meaning you won’t owe taxes on any investment gains or interest the annuity generates until your payments begin.

Moreover, annuities can be customized to meet your individual needs. For example, they can include options for spousal benefits, ensuring that a surviving spouse continues to receive income after the annuitant’s death.

Types of Guaranteed Lifetime Annuities

Yet, it’s critical to remember that guaranteed lifetime annuities are not a one-size-fits-all solution. There are various forms of these annuities, each with its unique set of characteristics and features. For example, immediate annuities start disbursing payments soon after the investment is made, providing an instant income source.

Conversely, deferred annuities begin payments at a future date specified in the contract, allowing for potentially larger payments later on. Other variations include fixed-rate annuities, which guarantee a specific return, as well as variable-rate annuities with returns linked to the performance of an investment portfolio.

Fixed vs. Variable Annuities

The choice between a fixed or variable interest rate is a key aspect of guaranteed lifetime annuities. Think of a fixed annuity as a steady stream, providing predictability and stability. It can be particularly beneficial for individuals seeking a consistent income during their retirement years.

In contrast, a variable annuity fluctuates based on the performance of the market. This introduces an element of risk to the investment, but also the potential for higher returns, making variable-rate annuities a more attractive option for those willing to accept some level of risk in their investment. Balancing the risk and reward between fixed and variable annuities is key to a successful retirement plan.

Immediate vs. Deferred Annuities

When comparing immediate and deferred annuities, the timing of income payouts is important. Immediate annuities offer prompt payments, making them an optimal choice for individuals near retirement who want an immediate income source.

Deferred annuities, on the other hand, yield larger payments but commence at a later date, presenting a more suitable option for those with some years remaining before retirement. This approach allows for a potentially augmented future income, albeit at the expense of immediate financial returns.

Ultimately, deciding between an immediate or deferred annuity will depend on whether you can afford to delay payments in favor of potential gains.

Who Receives the Payments?

When it comes to guaranteed lifetime annuities, another important consideration to make is whether you want someone else to continue to receive payments when you die.

On one hand, a single life guaranteed lifetime annuity will make payments to you for the rest of your life, but those payments will stop upon your death. A joint and survivor annuity, on the other hand, will include a provision that ensures your spouse will continue to receive payments – albeit smaller ones – from the annuity even after you die.  

Tax Treatment of Guaranteed Lifetime Annuities

A middle-age couple considers purchasing a deferred annuity that will make payments to them for life.

Just like other investments, annuities are subject to a unique set of taxation rules, which can significantly impact the overall returns of the investment. And, when considering taxes for a guaranteed lifetime annuity, you should note that the rules are different during accumulation and distribution phases.

Throughout the accumulation period, the funds that you invest grow tax-deferred. This means you won’t pay taxes on it until you start making withdrawals. But when the distribution phase begins, the income you receive from the annuity is taxed as ordinary income, which could potentially be higher than the capital gains tax rate.

As an example, if you invest $100,000 in a guaranteed lifetime annuity, and it grows to $200,000 during the accumulation phase, you won’t pay any taxes on the $100,000 gain until you start receiving payments in the distribution phase. At that point, those payments will be taxed as regular income.

Whether you owe taxes on the full payment or just the investment gains will depend on whether the annuity is qualified or non-qualified:

  • Qualified annuities: These annuities are funded with pre-tax dollars, meaning they can reduce your current taxable income. While this offers a tax benefit today, you’ll pay income taxes on all of the money you receive when the payments begin.
  • Non-qualified annuities: These annuities are funded with after-tax dollars, meaning you have already paid taxes on the money you used to purchase them. When you withdraw from a non-qualified annuity, you’re only taxed on the earnings, not the principal amount.

The Pros Guaranteed Lifetime Annuities

One key advantage of a guaranteed lifetime annuity is the option to generate retirement income. For example, if you were to invest $500,000 in an annuity that offers a 5% annual payout, you would receive $25,000 each year for the rest of your life.

Additionally, a guaranteed lifetime annuity could offer you tax-deferred growth. This means that you could benefit in two ways. First, taxes won’t chip away at the value of your annuity as it grows during the accumulation period, providing a significant advantage if you are in a higher tax bracket. And secondly, this tax deferment could also benefit you later again in retirement if your income falls in a lower tax bracket.

The Cons of Guaranteed Lifetime Annuities

While guaranteed lifetime annuities have several attractive features, it’s important not to overlook potential downsides. The lack of liquidity is a common disadvantage, especially when you need money for unexpected expenses. Annuities could make it difficult to withdraw without facing substantial surrender charges. And, if you’re younger than 59.5 years old, you could also face a 10% early withdrawal penalty from the IRS.

Inflation is another risk to consider. If your annuity does not include inflation protection, the purchasing power of your fixed payments might decline over time. This is particularly important to consider for those who plan to rely heavily on their annuity income in the latter years of retirement.

Furthermore, you could lose capital. If you die soon after investing, there may be little to no return of the original investment to your beneficiaries.

Should You Get a Guaranteed Lifetime Annuity?

A couple calculates how much retirement income they'll need and whether a guaranteed lifetime annuity is suitable.

Before investing in a guaranteed lifetime annuity, there are several factors to consider. Here are three things to help inform your decision:

  1. Consider your financial goals: Are you looking for a steady income in retirement, or are you more focused on preserving capital to leave a legacy for your heirs? Your priorities will significantly influence which investment products are best suited for your needs.
  2. Assess your risk tolerance: Can you tolerate the potential loss of capital if you die early? Or is your primary concern about outliving your savings? It’s crucial to balance these risks and consider how an annuity might fit into your overall financial plan.
  3. Consider your retirement income sources. Finally, do you have other sources of income, such as Social Security or a pension, or will this annuity be your primary source of income in retirement? If you’re heavily reliant on annuity income, it’s particularly important to understand the risks and potential drawbacks.

Bottom Line

A guaranteed lifetime annuity could provide additional stability and security for your golden years. These insurance contracts require you to make a lump sum payment or a series of payments in exchange for a guaranteed stream of income that lasts the rest of your life. As with any investment decision, it’s essential to do your homework and consider seeking professional advice.

Retirement Planning Tips

  • Like annuities, life insurance is another type of insurance product that may factor into your plan for retirement. If you’re in the market for life insurance, SmartAsset has a tool specifically designed to help you determine how much coverage you might need to buy.
  • Retirement planning can be complicated and potentially confusing, but a financial advisor can help you navigate this important process. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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