Traditional employer-sponsored defined benefit pension plans often take the form of annuities. Funds are deposited into the account for a number of years before the plan converts a lump sum into an income stream. In the absence of an employer-based plan, you can create your own income stream with an immediate or deferred annuity.
Insurance companies market annuities as life insurance contracts that provide lifetime benefits. Standard life insurance contracts provide financial benefits for your beneficiaries. With an annuity, the purchaser or other designated annuitant receives monthly income payments. You can structure an annuity so you get lifetime payments, or you can buy one that provides payments for a limited term. Some people buy limited term annuities to generate income in the gap years between retirement and the commencement of Social Security payments.
Traditional pension plans are funded with pre-tax money known as qualified funds. Consequently, your withdrawals are subject to income tax. In contrast, you can buy an annuity with qualified retirement money or so-called nonqualified funds, which have already been subjected to income tax. Once inside an account, the money grows tax deferred. On a nonqualified contract, your purchase premium represents your non-taxable cost basis. You only pay taxes on the portion of the proceeds that exceeds your original investment.
You can create an instant income source by purchasing an immediate annuity. You buy the contract with a single premium payment. The insurance company converts the premium into an income stream through a process called annuitization. Income payments normally begin within a month of the purchase date. With a nonqualified annuity, each payment consists of a return of premium combined with some taxable earnings. This payout method keeps your taxes to a minimum by spreading your tax liability over several years.
You can grow your nest egg before annuitization by investing in a deferred annuity. On a variable annuity, your premiums are invested in mutual funds for several years. When the contract matures, you generally get income based on your original investment or the current cash value of the contract -- whichever is higher. In a fixed annuity, you earn a fixed rate of interest for a number of years. Equity indexed annuities are more complex. Your returns are based on the performance of a related stock market index. If the market performs badly, you typically receive income payments based on a portion of your original investment plus some interest that you earn on that sum.
Annuities take some of the guesswork out of retirement because you assure yourself of a monthly income stream. However, you usually have to pay hefty surrender penalties if you make withdrawals before your contract matures. You also pay a 10 percent tax penalty on earnings and tax-qualified contributions if you access funds before reaching the age of 59 1/2. The annuitization process is also irrevocable. This means you cannot cash in your account once the income payments begin.
- Bankrate: Immediate Annuities -- Do It Yourself Pensions
- National Association of Insurance Commissioners: Annuities and Senior Citizens
- Financial Industry Regulatory Authority: Equity-Indexed Annuities -- A Complex Choice
- U.S. Securities and Exchange Commission: Variable Annuities -- What You Should Know
- Internal Revenue Service: Annuity