A life annuity is a new name for an old product, in which an insurance company, in exchange for one or more premium payments, contracts to make monthly payments for life to an annuitant.
We've explored issues surrounding the insurance companies that issue annuities and their agents, and we've examined the different ways annuities gain in value. We've also analyzed potentially troublesome elements of the annuity contract itself. Now we'll review the different types of settlement – that is, the different kinds of monthly income stream to which an annuity can be converted.
Annuitization – Converting a Lump Sum to a Guaranteed Monthly Income Stream
Annuities can be annuitized – converted to a guaranteed monthly income stream – at any point, without penalty, unless otherwise stated in the annuity contract, as long as they don't include tax-qualified funds. The amount of the monthly payment is based on the value of the annuity and the age of the annuitant. Two things to keep in mind:
- If the annuity is an IRA – that is, was created by the rollover of tax-qualified funds – it generally cannot be annuitized before the annuitant turns age 59½. The other point is that the IRS requires that annuitants must take required minimum distributions (RMDs) starting the year they turn 70½ from any non-annuitized annuity.
- Annuitization is an irrevocable decision. Once made, it cannot be reversed, and the insurance company's only obligation is to deliver that monthly payment. The annuitant no longer controls the large sum of money that used to be the annuity, and cannot turn back the clock on the annuitization decision – not even by returning all money paid out. Too often, annuitants think there's some sort of emergency way for them to access the annuity's account value. This is a critically important fact: once annuitized, an annuity is just a guaranteed monthly check.
Types of Guaranteed Monthly Annuity Payments
Most annuities permit the annuitant to select the type of settlement arrangement at the time they make the decision to annuitize. Of course, most individual annuitants select the traditional annuity, the life annuity: guaranteed monthly payments for life.
One of the most popular variations of the traditional annuity is the joint annuity, issued to a couple and paid out monthly until both joint annuitants have died. The purpose of the joint annuity is to avoid the situation of one spouse in a couple receiving monthly annuity payments and dying, leaving the survivor without that income.
A guaranteed annuity is a feature that can be applied to any annuity. One of the drawbacks to annuities was that if the annuitant died before the value of the annuity was exhausted, the remaining amount would be forfeited to the insurance company. A guaranteed annuity provides for the continuation of annuity payments for a “period certain” even if the annuitant dies beforehand. This guarantees that the full pre-annuitization value of the annuity will be paid out. Of course, if the annuitant lives beyond the period certain, the payments must continue.
Another form of annuity gaining popularity is the impaired life annuity. This annuity is issued to those with medical diagnoses so severe that their life expectancies are considered to be diminished. Because of the reduced life expectancy, the monthly payouts are significantly higher than they would be if the annuitant's life expectancy was normal. This form of annuity requires some medical underwriting.
Fixed term annuities are established to provide the monthly income stream for just a fixed period of time, after which the payments stop. The most common example of a fixed term annuity is a lottery prize, which is usually available as a single lump sum or in twenty annual installments.
Probate and Tax Implications of Not Annuitizing
While it's important to choose the annuitization option that's most suitable for their particular situation, consumers should also keep in mind that less than 10% of all annuities are actually converted to a guaranteed monthly income stream. In some cases, annuities are cashed in and the funds used for whatever purpose the owner desires.
In most cases, though, the annuitant dies before annuitization, so that the annuity is paid to the beneficiary. These payments usually bypass the probate process, but there are significant tax consequences for the beneficiary – if the annuity is an IRA, the entire value is immediately taxable as ordinary income; if the principal is non-qualified, then that portion of the annuity's value attributable to interest is taxable.
Dale Marshall - After a fairly long, often rewarding and frequently frustrating career in the corporate and semi-corporate world, I passed age 45 and ...
