How to Pick the Right Payout Option for Your Annuity

For some investors, an annuity can be an appropriate part of a sound financial plan. However, one factor that is commonly misunderstood is annuity payout options. Below, we define these options, how they are calculated, and how they are taxed.

What Is an Annuity?

An annuity is an insurance contract that provides retirement income. There are two phases: the accumulation phase and the annuitization phase (the payout phase). During the accumulation phase, you can add funds to your annuity contract by depositing cash, converting life insurance cash values, and doing a 1035 exchange from another annuity.

If you follow the annuity rules, your annuity will accumulate earnings on a tax-deferred basis until you begin to make withdrawals, which are often paid through ACH transfers.

Once you reach age 59½, you can begin to withdraw money from an annuity without penalty.

Annuity Payout Options

There are a few different methods for taking annuity payouts. The most common methods are:

• The annuitization method
• The systematic withdrawal schedule
• The lump-sum payment

The annuitization method gives you some guarantee of monthly income for a determined period or for life. Under the systematic withdrawal schedule, you have complete control over the timing of distributions but no protection against outliving annuity assets. The lump-sum payment distributes funds all at once.

Life Annuitization Option

You'll receive the most per month with this option, which gives you income for the rest of your life. There is no income beyond your death; it's only for the life of you, the annuitant.

Joint-Life Annuitization Option

This common option allows you to pass on the income to your spouse upon your death. The monthly payment is lower than that of the life option, because the calculation is based on the life expectancy of both spouses.

Period Certain Annuitization Option

With this option, the value of your annuity is paid out over a defined period of time of your choosing, such as 10, 15, or 20 years. Should you elect a 15-year period certain and die within the first 10 years, the contract is guaranteed to pay your beneficiary for the remaining five years.

Life With Guaranteed Term Option

Many people like the idea of income for life (which they get with the life option), but they are afraid to choose it in case they die in the near future.

The life with guaranteed term option gives you an income stream for life (like the life option). However, with this option, you can select a guaranteed period, such as a 10-year guaranteed term, for which your annuity is obligated to pay to your estate or beneficiaries even if you die before that guaranteed period is over.

Systematic Withdrawals Option

Under this method, you select the payment you want to receive each month and how many payments you want to receive overall. What you receive and how many months you receive payments depends on how much you have in the account.

However, the insurance company won’t guarantee that you won’t outlive your income payments. The burden of life expectancy risk is on your shoulders.

Lump-Sum Payment Option

It's typically not a good idea to withdraw a lump sum payment from your annuity, because you'll need to pay ordinary income taxes all at once, right away.

Monthly Payment Calculation

There are several factors that insurance companies use to compute your monthly payment amount, but two of the most common are gender and age—both of which affect your life expectancy. As women typically have a longer life expectancy than men, they will not receive as high of a monthly payment as their male counterparts. And, of course, the older you are, the lower your life expectancy. Thus, a 75-year-old man with the life option will receive a higher monthly payout than a 65-year-old man.

Another major factor that affects the size of your monthly payout is the payout option that you select, which affects how long the payments will last. For example, if you select the joint-life option, your monthly payout most likely will be lower, as the payment continues to your spouse after your death.

Finally, the size of your monthly payout depends on the insurance company that you use and its expected investment returns on your money. However, the increase in your payment when returns are higher depends on whether you select a fixed monthly payout or a variable monthly payout from your annuity. If you select the fixed amount, your payout will not change, and the insurance company assumes all investment risk. Under the variable payout, the size of the monthly payout fluctuates based on market conditions, so you assume the market risk. The details can get complex, though, so be sure to read the fine print.

Annuity Payout Tax

Once you select your payout method, you should ask for your exclusion ratio, which tells you how much of your payment is excluded from being taxed. If your exclusion ratio is 80% on a $1,000 monthly payout, then $800 is excluded from income tax, and $200 is subject to taxation.

Any withdrawal before age 59 ½ is considered a premature distribution, and is subject to a 10% tax penalty, plus income tax on what you withdraw as earnings — and earnings typically come out first. (This is the case for annuities purchased after Aug. 14, 1982.)

Credit Quality Concerns

A final factor to consider is the credit quality of the insurance company. Remember that just because you have accumulated your annuity at one insurance company over the past 20 years, you do not necessarily need to start your payouts with it.

The insurance companies have employees who will provide you with an estimated payout for each option. Make them earn the fees that they charge. Have multiple quality insurance companies give you a quote on the current value of your annuity with multiple payout options.

The Bottom Line

Deciding the best payout method for your annuity is not easy. Consider your priorities, the amount you need each month, and how long you think you will need these payments.

Of course, you can elect to take no payments at all. Some individuals have no need for income from the funds that have accumulated in their annuity. If the same is true for you, be sure to check that, if applicable, your beneficiary designation is correct, as some annuities can be transferred to your beneficiary after your death.