Immediate Annuities

How it works

A single premium is paid once, in full, and the transaction is irrevocable from that point forward. The insurer books the payment as its investment in the contract and begins payments one interval later, monthly, quarterly, or annually depending on what was elected at application. There is no accumulation phase and no account balance to check; the contract exists only as a schedule of future payments.

The payout option chosen determines the entire economics of the contract. Life only pays for as long as the annuitant lives and nothing after. Life with period certain, commonly 10 or 20 years, guarantees payments for that span even if the annuitant dies early, then continues only if still living. Joint and survivor covers two lives with a stated continuation percentage to the survivor. Cash refund and installment refund guarantee that total payments will at least equal the premium paid, returning any shortfall to a beneficiary. Period certain only drops the life contingency entirely and simply pays a fixed number of years regardless of survival.

Mortality credits are what let a life-contingent payout exceed what a bond ladder of the same maturity could produce. Premium left behind by annuitants in the pool who die earlier than expected is redistributed to those who live longer, subsidizing their payments. Pricing starts from the annuitant's age and, for non-qualified contracts in most states, sex, and impaired-risk or medically underwritten SPIAs raise the payment further by shortening the assumed life expectancy based on documented health conditions.

The payment obligation sits on the insurer's general account, invested mainly in investment-grade bonds, private placements, and commercial mortgages, and it is a general corporate obligation rather than money segregated in the buyer's name. Quotes are firm only for a short rate-lock window because pricing tracks bond yields daily. Purchase is by application and either a check or a 1035 exchange from an existing annuity, and every state provides a free-look period, length varying by state, during which the contract can be unwound. Inflation-linked versions, whether a fixed annual step-up or CPI linkage, start noticeably lower than a level payment funded by the same premium.

What it pays

Payments are quoted as income per period per $100,000 of premium, or as a payout rate equal to annual income divided by premium. That payout rate is not a yield. Especially in the early years, most of each payment is the buyer's own principal being returned, with interest and, on life contracts, mortality credits layered on top.

Four variables set the number: age at purchase, the payout option selected, whether the contract covers one life or two, and the level of intermediate and long-term interest rates on the pricing date. Older buyers receive more per dollar of premium because their expected payment period is shorter and the mortality credit is larger. Life only pays the most of any option; adding a period certain, a cash refund, or a second life all lower the payment, because each feature returns part of the mortality subsidy to the buyer or a beneficiary instead of keeping it in the pool.

Once issued, a level-payment contract pays the same amount for the rest of its term or the annuitant's life, with no adjustment unless a cost-of-living rider was purchased at the outset. Identical age, sex, and payout option can still produce different quotes from different carriers, since each insurer prices off its own mortality tables, portfolio yield, expense loads, and commission structure, which is why shopping multiple carriers changes the outcome even with no change in terms.

For non-qualified premium, the after-tax payment in early years is higher than the gross number suggests, because a portion is a tax-free return of the buyer's own capital rather than income.

Costs and taxes

There is no visible fee schedule. Commission, administrative expense, and insurer profit are all embedded inside the quoted payment rather than billed separately, so the only meaningful way to compare offers is the income delivered per dollar of premium across carriers.

For a non-qualified purchase, IRC section 72 applies an exclusion ratio that splits every payment into a tax-free return of the investment in the contract and a taxable ordinary-income portion, based on expected return under IRS actuarial tables. Once the full investment in the contract has been recovered, which happens automatically if a life annuitant outlives the table, every later payment becomes fully taxable ordinary income. If the annuitant dies before recovering that basis, the unrecovered amount is generally deductible on the final tax return.

Money annuitized from an IRA or a 401(k) rollover carries no basis, so the entire payment is ordinary income, though annuitizing that balance satisfies the required minimum distribution on the portion converted. There is no capital gains treatment anywhere in this structure, no qualified dividend rate, and no ability to harvest a loss inside the contract; every dollar received is ordinary income.

A small number of states impose a premium tax on annuity purchases, deducted from the premium or reflected as a lower payment before the quote is even generated. The taxable share of each payment also counts toward modified adjusted gross income, which feeds into the taxation of Social Security benefits and the income brackets for Medicare's IRMAA surcharge.

Liquidity and time commitment

The purchase is irrevocable in almost every contract sold. There is no account value to surrender, nothing to borrow against, and no mechanism to alter the payment schedule once the contract is issued. A minority of carriers permit commutation, exchanging remaining period-certain payments for a discounted lump sum, but true life-contingent payments are rarely commutable under any circumstance.

Period certain, cash refund, and installment refund features exist to protect a beneficiary if the annuitant dies early, not to give the living owner any access to the money. None of these features can be tapped for a medical bill, a home repair, or a market opportunity; the capital is committed for good, and that permanence is the mechanism that funds the mortality credit in the first place.

Once the contract is issued, the ongoing time commitment is close to zero: a payment arrives on schedule and a Form 1099-R arrives each January for tax filing. The workload is nearly nil, but because the capital cannot be recovered, the practical commitment is measured in decades.

How it goes wrong

A level nominal payment loses purchasing power every year inflation runs above zero, and over a multi-decade retirement that erosion can cut real income substantially with no catch-up mechanism inside the contract. Pricing is also locked permanently at the purchase date; a contract bought when interest rates were low stays at that payment level forever, with no re-rating as rates later rise.

A life-only payout combined with an early death means the insurer retains the remaining balance and heirs receive nothing, the single outcome families complain about most, even though it is the exact mechanism that funds the higher payments received by longer-lived annuitants in the same pool.

If the insurer becomes insolvent, the contract falls to the state guaranty association in the buyer's state of residence, which covers the present value of annuity benefits only up to statutory limits that vary by state; anything above that limit has no backstop.

Mistaking the quoted payout rate for a yield leads buyers to overestimate how much interest the contract is actually earning, since a large share of each payment is simply principal coming back. Committing too large a share of a portfolio to an irreversible annuity leaves no reserve for lump-sum needs later, and commission incentives can steer a buyer who wanted a plain SPIA toward a more complex deferred contract with riders that cost more and pay less income today.