You can simplify your finances during your retirement years by purchasing a guaranteed lifetime income annuity. Essentially, these contracts protect you from the financial consequences of your own longevity. As with any insurance contract, the protection comes at a cost. However, you can buy policy guarantees known as riders that protect your investment if you die sooner than anticipated.
You buy a guaranteed lifetime income annuity with a single purchase premium. The annuity company multiplies your investment by a set rate of interest. That sum of money is then divided into monthly income payments that are designed to last you for life. Annuity companies usually work on the premise that no one lives past the age of 100. Therefore, you get all of your principal and interest if you live to that age. If you live past 100, the income payments continue, but the annuity company has to fund the payments with its own money. In reality, annuity companies fund additional payments with premiums left over from other annuitants who died prematurely.
An annuity grows on a tax-deferred basis. You pay income tax on your earnings as you make withdrawals. Guaranteed lifetime income annuity payments are structured so that each payment consists of both a nontaxable return of premium and some taxable interest. This means you receive your taxable interest incrementally over a period of years. This means you pay less in taxes than you would if you received it all within the same tax year. If you buy an annuity with tax-deferred funds from a 401(k) or pension, you pay taxes on withdrawals of both principal and interest.
Aside from individual annuities, you can also buy joint annuities that generate income payments until the last surviving owner dies. Monthly payments are lower on joint contracts than on individual policies. Simply put, when two people are involved, there is twice as much chance of an annuitant living past 100. You can also buy riders to assure your beneficiaries of a lump sum payout if you die sooner than anticipated. The payout normally amounts to your initial investment minus payments you received and charges. As with joint owners, riders usually result in a decreased monthly income benefit.
A basic lifetime income annuity contract exposes you to inflation risk. Monthly payments usually remain flat throughout the contract, while inflation may cause your living expenses to rise. Consequently, some firms offer inflation protection riders. Offerings vary, but in some instances your income rises by a set percentage each year. Other contracts are indexed to inflationary measures such as the Consumer Price Index. Such riders are beneficial in the long run but result in smaller income payments during the early years of the contract.