Annuities are a popular investment option for individuals seeking retirement income. They provide a reliable income stream that can last a person’s lifetime, but not all annuities work the same way. For example, some annuities require annuitization, while others don’t. In this guide, we’ll explore the types of annuities that require annuitization and explain what it means for investors.
What Is Annuitization?
Annuitization is when the investor converts the value of their annuity contract into a stream of income payments. Once annuitization occurs, the investor typically cannot change the payment amount or frequency. Instead, they receive a fixed payment amount for a predetermined length of time, which can be for the rest of their life or a specified period.
Types of annuities that require annuitization
Not all annuities require annuitization, but some types of annuities do. The most common types of annuities that require annuitization include the following:
- Single premium immediate annuities (SPIAs)
- Deferred income annuities (DIAs)
- Qualified longevity annuity contracts (QLACs)
- Structured Settlements
- Two-Tiered Annuities
When does annuitization occur?
Annuities that require annuitization typically have a specific triggering event that causes the conversion. For example, with an SPIA, the investor purchases the annuity with a lump sum of money, and annuitization occurs immediately. With a DIA, the investor purchases the annuity but defers annuitization until a future date. Finally, with a QLAC, the investor uses a portion of their IRA or 401(k) to purchase the annuity, and annuitization occurs at a specific age.
Advantages of annuitization
While annuitization may not be suitable for everyone, there are some advantages to this type of annuity.
Guaranteed Income
Annuities that require annuitization provide a guaranteed income stream for the investor’s lifetime or a predetermined period. This can provide peace of mind for retirees worried about running out of money for retirement.
Tax Benefits
Annuities that require annuitization can provide tax benefits for investors. The income received from the annuity is typically taxed at a lower rate than other types of income, and in some cases, the investor may be able to defer taxes until the income is received.
No Investment Risk
Investors who purchase annuities that require annuitization are not exposed to investment risk. Instead, they are guaranteed a fixed income stream regardless of what happens in the financial markets.
Disadvantages of annuitization
While there are advantages to annuitization, there are also some disadvantages to consider.
No Flexibility
Once annuitization occurs, the investor typically cannot change the payment amount or frequency. This can be problematic if the investor’s financial needs change.
Limited Access to Funds
Investors who purchase annuities that require annuitization typically have limited access to their funds. In addition, once the annuity is annuitized, the investor cannot withdraw the principal.
Inflation Risk
Investors who purchase annuities that require annuitization are exposed to inflation risk. This is because the fixed payment amount they receive may not keep up with inflation, which can erode the purchasing power of their income over time.
No Death Benefit
Annuitized payouts may or may not offer a death benefit to beneficiaries. If a death benefit is offered, a series of payments is the standard method of distributing the proceeds.
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Which Annuity Does Not Require Annuitization?
All annuities offer the ability to annuitize the contract. However, not all annuities require annuitization. The following annuity types offer this feature as an option but are not required:
The Alternative To Annuitization
Lifetime income riders or Guaranteed Lifetime Withdrawal Benefits are not a form of annuitization but provide a similar solution: receiving payments for the rest of your life. You can choose an income rider if you do not want to annuitize the annuity and still create a guaranteed income for life.
So let’s review your options below and check for annuities requiring you to annuitize your contract.
Annuitization Payout Options
There are seven annuitization payout options, but they can vary from product to product. Below are the seven types to help you make a better decision.
Fixed period (Period Certain Annuity)
What is the annuitization period? “Annuity Certain” or “Annuity Period Certain” is when payments are distributed to you for a fixed period.
In most cases, you can choose a period ranging from 5 to 30 years with a particular annuity.
If you die before the end of the fixed period, the payments continue to pay your designated beneficiary until the period is up.
Because annuitization rates are low, you’re paying yourself back over time with a little bit of interest, which is currently around 1.25%.
You can find certain period annuities here.
Single Lifetime Income (Straight Life Annuity)
Individuals who purchase a single-life annuity are given protection against running out of money during their lifetime. Payments from a straight-life annuity are distributed to you for the rest of your life until the day you die, guaranteed.
Typically there is no death benefit to heirs.
The life-only annuity payout usually distributes the highest income out of all annualizations.
You can find single-life annuities here.
Joint and Survivor (The Couples Annuity)
Payments are made to you for the rest of your life until the day you die.
When you die, the surviving spouse will continue to receive annuity payments for the rest of their life.
One can choose a payment reduction (50% to 100%) for the surviving spouse in exchange for a higher annuity payment upfront.
Once the surviving spouse dies, there is no death benefit typically.
You can find joint and survivor annuities here.
Lifetime Income with a Guaranteed Period (Life Annuity with Period Certain Annuity)
With a straight life annuity with a certain period, your annuity payments are paid to you until the day you pass away, with a guaranteed period that acts as a backup plan in case of premature death.
If one of the annuitants (you) dies before the guaranteed period expires, payments continue to pay your designated beneficiary until the period has expired.
Consider this a hybrid payout for Single Life Only Annuity and the Period Certain. This payout option can also be applied to a Joint and Survivor payout.
You can find life annuities with a period certain here.
A lifetime with Cash Refund (Refund Annuity)
The annuitant will receive payments for the rest of their life until the day they or they die.
If the annuitant (you) dies before receiving your original investment amount, the designated beneficiary pays the difference in a lump sum.
Sometimes called a “Cash Annuity.”
A lifetime with Installment Refund
The installment refund annuity payments will be distributed for the rest of the annuitant’s life.
If the annuitant dies before receiving the original investment amount back, the difference is paid to the designated beneficiary over installments until the original investment is paid back.
Also called an “Installment Refund Annuity” or “refund life settlement option.”
Inflation
Most annualizations allow you to elect an optional Cost of Living Adjustment (COLA) to your annuity payments.
The payments will start lower than most but increase yearly, mimicking inflation.
You get to choose how much of an increase you receive each year in most cases.
Tax Advantages
Nonqualified Annuities
Since nonqualified annuities are purchased with “after-taxed” money, only the interest portion of your annuity payment is taxable.
Under current tax law, part of each annuity payment you receive is a return on your original principal, which means part of your annuity payment will be taxed, and the other part not.
Qualified Annuities
Generally, your payments are fully taxable because the funds have not been taxed yet.
Since annuity payments will be distributed over time, you spread the tax liability over time (instead of a lump sum).
Deferring your annuity payments (Not Immediate annuities) over time may lead you into a lower tax bracket when you start collecting your annuity payments.
Annuitization At a glance
| Variable Annuity | Fixed Index Annuity | Fixed Annuity | Immediate Annuity | Deferred Income Annuity | Buffer Annuity | |
|---|---|---|---|---|---|---|
| Principal Protection | No | Yes | Yes | Yes | Yes | No |
| Access To Principal | Yes | Yes | Yes | No | No | Yes |
| Annuitization | Optional | Optional | Optional | Mandatory | Mandatory | Optional |
| Tax-Deferred Growth | Yes | Yes | Yes | No | No | Yes |
| Guaranteed Growth | No | Yes | Yes | No | No | No |
| Guaranteed Income | Yes | Yes | Yes | Yes | Yes | Yes |
| Inflation Protection | Yes | Yes | No | Yes | Yes | Yes |
| Death Benefit | Yes | Yes | Yes | Yes/No | Yes/No | Yes |
| Long-Term Care Help | Yes | Yes | Yes | No | No | Yes |
Next Steps
Annuities can be a valuable investment tool for individuals seeking retirement income. At the same time, not all annuities require annuitization. Those that offer a reliable income stream can provide peace of mind in retirement.
Annuities that require annuitization also offer tax benefits and protect investors from investment risk. However, disadvantages exist, such as limited access to funds, inflation risk, and a lack of flexibility once annuitization occurs.
Therefore, it’s essential to carefully consider all factors before purchasing an annuity that requires annuitization and to consult with a financial advisor to ensure it’s the right investment option for your unique situation. Investors can make informed decisions about their retirement income strategy by taking a people-first approach and focusing on the benefits and drawbacks of annuitization.
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Frequently asked questions
Why should I annuitize annuity payments?
You guarantee an income stream for the rest of your life or a fixed period. Therefore, one should consider annuitization as adding an extra layer of retirement income complementing Social Security Income.
If an annuitant dies before annuitization occurs, what will the beneficiary receive?
Typically the annuity’s account value will be distributed to the designated beneficiary in a lump sum. However, with that said, a few annuity contracts will distribute the annuity’s value over a fixed period.
Can I change my mind after annuitizing?
No. The decision to annuitize the annuity is final. You can not switch your annuity payment option either. In most cases, you will not be able to withdraw additional funds from your annuity either. Always have additional funds that are liquid in case of an emergency.
What is the annuitization period?
The annuitization period is when an annuity distributes a series of payments to the contract owner. The annuitization period begins once the annuity owner has received the first payment.
What happens when an annuity ends?
When an annuity ends, the outcome depends on the type of annuity and the specific terms of the contract. A life annuity will continue to make payments until the annuitant’s death. A fixed-term annuity will end when the term is up, with the remaining balance paid out in a lump sum or rolled over into another investment. A deferred annuity will typically convert to a life annuity or an annuity with a fixed payout period when it matures.
How does an annuity payout work?
An annuity payout is how an insurance company distributes income from an annuity contract to the annuitant. The type of annuity and terms of the contract determine the type of payout, such as immediate, deferred, life, joint life, fixed-term, or variable annuity. It’s important to understand options and choose the right type of annuity. Consulting with a financial advisor can help ensure the best decision.
If an annuitant dies before annuitization occurs, what will the beneficiary receive?
If an annuitant dies before annuitization, the beneficiary may receive a death benefit, a portion of payments, or the contract may be transferred to a designated beneficiary, depending on the type of annuity and terms of the contract.
What happens at the end of an annuity contract?
The outcome at the end of an annuity contract depends on its type: immediate payments continue for life, deferred payments start later, fixed-term payments end after a set number of years, variable payments continue while there is value in investments, life payments continue for life, joint life payments continue for both annuitant and beneficiary.
What to do when the annuity matures?
When an annuity matures, the annuitant can choose a lump sum payout or start receiving annuity payments.
Are annuity payments guaranteed?
Annuity payments can be guaranteed, but it depends on the type. For example, fixed annuities offer a guaranteed interest rate for a set period. In contrast, variable annuities are linked to the performance of underlying investments and do not guarantee a specific rate of return. In addition, immediate annuities provide a guaranteed income stream for life, while deferred annuities guarantee the original investment principal.
How long are annuities?
The length of annuities can vary, depending on the type of annuity and the terms of the contract. Annuities can be structured as short-term or long-term investments, with terms ranging from a few years to several decades. Some annuities have a fixed term, while others provide income for the lifetime of the annuity holder.
What does it mean to annuitize a contract?
Annuitizing a contract means converting an investment or savings product into a stream of income payments. In the context of an annuity, annuitization refers to the process of electing to receive guaranteed income payments from an insurance company for a specified period of time or for the lifetime of the annuity holder.
What will the beneficiary receive if an annuitant dies?
The beneficiary of an annuity will receive payments from the insurance company if the annuitant (the person who owns the annuity contract) dies before the full value of the annuity has been paid out.