When you want to guarantee an income in retirement, an immediate annuity can provide that income for a specific amount of time or for your entire lifetime. The immediate annuity can be tailored to pay based on your life only or on the lives of both you and your spouse, ensuring financial security even after one spouse dies. How much money you need for an immediate annuity generally depends on your retirement income needs.
Nature of Immediate Annuities
The main advantage of an immediate annuity is the guaranteed income stream that remains unchanged, unaffected by market conditions. However, that same advantage can be seen as a disadvantage. Immediate annuities are locked in and therefore offer no flexibility or liquidity when interest rates or your income needs change. For that reason, you should consider an immediate annuity to cover only those income needs that are guaranteed to continue over time and stay fairly predictable, such as basic living expenses, utilities, medications and travel.
Design a budget for your retirement years and identify which expenses you expect to stay with you throughout your retirement years and remain fairly predictable. Consult with a financial planner to obtain an estimate of the amount you would need to purchase a life income annuity (an annuity that pays you an income as long as you are alive) to fund those ongoing income needs. Alternatively, you can use one of a number of life income calculators available online. If you were a 65-year-old male and identified a remaining lifetime income need of $2,000 a month to cover basic living expenses, you would need roughly $352,900 of investment to purchase a life annuity on yourself paying $2,000 a month for life. A life annuity on yourself and your wife of age 65 would require roughly $422,751.
An ordinary life annuity typically provides no refunds of unpaid capital should you die prematurely. The insurance company treats this as a "mortality gain." To protect your capital against premature death, consider building in a minimum guarantee. One typical guarantee period is 10 years, where the payments continue to your heirs until 10 years from the initial annuity payment if you die before receiving 10 years of payments. The purchase price of such annuity would be higher however in order to pay for the guarantee. A single life annuity on yourself alone would now cost $367,215 and a joint life annuity on yourself and your spouse would cost $425,782.
You must also consider the impact of taxation on your annuity payments. If you purchase your annuity with tax-deferred funds, such as those earned through a 401(k) or a traditional IRA, the entire annuity payment will be taxable. If you are in a 20 percent tax bracket and want to receive $2,000 monthly after tax, you need to generate $2,500 of pretax income. Once you pay the 20 percent tax of $500 you are left with a net of $2,000. This represents an increased income requirement on a pretax basis of 25 percent ($2,500 over $2,000) that you must adjust your life annuity calculations to include.
Philippe Lanctot started writing for business trade publications in 1990. He has contributed copy for the "Canadian Insurance Journal" and has been the co-author of text for life insurance company marketing guides. He holds a Bachelor of Science in mathematics from the University of Montreal with a minor in English.