Immediate income annuity explained: How do they work?

If you want to put your savings to work and start earning passive income right away, an immediate annuity is a great option. It turns a lump sum into a regular series of payments, which can help with financial goals like supplementing retirement income or supporting loved ones.

In this article, we’ll explain what an immediate annuity is to help you decide if it aligns with your financial goals.

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What’s an immediate annuity? How immediate annuities work

An immediate annuity is a contract between you and an insurance provider, where you pay a lump sum of money upfront in exchange for a guaranteed income. To determine the amount of money you’ll receive, the insurance provider considers factors like your age, health, and any riders or specific contract terms you select.

A typical payout rate is 4–6% of your initial contribution but can vary by insurer. And several contract features may influence how and when you receive your payments, such as:

• Payment schedules: While monthly distributions are common, some contracts offer quarterly or annual payment options.
• Start date flexibility: Most immediate annuities begin paying out within 30 days, though an insurer may allow you to defer this for up to a year — rarely longer. 
• Fixed versus adjustable income: A fixed immediate annuity provides the same payment amount throughout the contract period. But an immediate variable annuity offers payments that fluctuate based on the performance of underlying investments.
• Contract length: Accounts like immediate lifetime annuities guarantee payments for the rest of your life, but short-term contracts are also available. For example, if you retire at 62 but wait until 70 to claim maximum Social Security benefits, you can opt for an eight-year immediate annuity to supplement income in the meantime.

These contractual variations let you tailor your immediate annuity plan to your unique needs. Be aware, however, that contract customizations can involve trade-offs, such as reduced payout rates, added fees, or limited liquidity. 

Immediate annuity vs. deferred annuity

The main difference between immediate and deferred annuities is their payout schedule. Immediate annuities can start sending you money as soon as 30 days after purchase, while deferred annuity income is delayed for many years. 

A deferred annuity has two phases: Growth and payout. During the growth phase, you make your contributions and grow your money tax-deferred. Your contribution may be made in a lump sum or through regular payments. Likewise, during the payout phase, you may receive your income in a lump sum or through regular withdrawals. 

Conversely, immediate annuities usually only have one phase: payout. You make a lump sum contribution and begin receiving income within a year in regular payments.

Immediate annuities typically appeal to those seeking income right away, while deferred annuities better suit those who want to grow their funds before converting them to income down the road.

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3 types of immediate annuities

There are three main types of immediate annuities: Fixed, variable, and indexed. Here’s a look into each. 

1. Fixed immediate annuity

A fixed immediate annuity is the most common type. It provides a guaranteed payment amount for the duration of the contract — typically for life. Because market fluctuations don’t influence the payout, you can count on predictable income from these accounts. But the trade-off for this stability is often a lower potential payout compared to variable or indexed annuities.

2. Variable immediate annuity

When you purchase a variable annuity, you’ll choose from a range of mutual-fund-like options called subaccounts to invest in. These portfolios contain assets like stocks, bonds, and money market funds. 

Your payouts may change based on the performance of these subaccounts. If the underlying investments perform well, your payouts increase — but if they underperform, your payments decrease. This type of annuity may suit you if you’re interested in higher potential returns and comfortable with market fluctuations.

3. Indexed immediate annuity

An indexed immediate annuity ties your payments to the performance of a specific market index like the S&P 500^®. But to protect you from market volatility, these contracts include a minimum guaranteed payment amount. Even if rates drop, you still receive a base payout. 

However, this protection comes with a slight catch: Companies typically cap your earnings. So, while you may be safe from downturns, you may not have as much growth opportunity either.

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Immediate annuity pros and cons 

The main advantage of immediate annuities is that they offer an immediate guaranteed income at very low risk. They’re also a reliable yet simplified way of managing wealth.

And, because of the increasing modernization of annuities, you can tailor your contract to your needs with add-ons called riders. Here are a few common rider options:

• Cost-of-living adjustment (COLA) riders automatically increase your annuity payments each year by a set percentage to help offset inflation.
• Commutation or liquidity riders allow partial lump-sum withdrawals (within certain limits) in case of emergencies, offering some degree of access to your funds.
• Death benefit riders ensure beneficiaries receive either the remaining contract value or a preset amount if you pass away before recovering your entire premium.
• Long-term care riders increase your payout or provide a lump-sum benefit if you require assisted living services.
• Return-of-premium riders guarantee that if you pass away early — or decide to exit the contract — you or your beneficiaries recoup at least the premium you initially paid, minus any payments already received.

Depending on your contract, immediate annuities can also offer tax advantages. For example, if you buy an immediate annuity with after-tax money, only part of each income payment is taxed — this is known as the exclusion ratio.

Immediate annuity potential downsides

Gaining a secure, steady income with an immediate annuity means potentially limiting your returns. Because you’re protected from market downturns, you also sacrifice the potential for higher earnings if the market does well. 

Plus, if you need immediate access to funds, you may face surrender charges or restrictions that make it difficult and expensive to withdraw cash, so an emergency fund is a must. 

And the income from your immediate annuity depends on the size of your initial contribution — a larger contribution means higher income potential. If you have limited savings to contribute, this may prevent you from generating enough money to meet your financial goals.

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Immediate annuity payment structures

Depending on your contract, immediate annuities distribute funds in different ways. Here’s a look at the most common options:

• Single life: This structure pays income for the rest of your life, but no benefits transfer to beneficiaries. Generally, if there’s any remaining principal, the insurance company keeps it.
• Single life with period certain: This option provides payments for your lifetime and guarantees a minimum payment period. If you die before the period ends, your beneficiary continues to receive payments until the term expires.
• Single life with refund: This structure pays income for life, and if you die before recovering the entire premium, the remaining balance goes to a beneficiary. In other words, it guarantees that you or your heirs will recoup at least the amount of your initial contribution.
• Joint and survivor: This arrangement covers two individuals, often spouses, and continues paying income as long as at least one is alive. When one person passes away, the surviving individual keeps receiving payments — potentially at a reduced rate, depending on the contract.
• Joint life with period certain: This structure combines joint coverage with a guaranteed payment term. If both individuals die before the term ends, a beneficiary receives the remaining payments for the rest of the fixed period.
• Period certain only: This option provides payments for a specified number of years — without tying them to anyone’s lifetime. If you die during this timeframe, your beneficiary receives the remaining payments until the term concludes.

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FAQs

Are fixed immediate annuities a good retirement option?

If you want a steady, guaranteed income for retirement, immediate annuities may be a sound retirement option. And with additional rider options, you can tailor these contracts to your needs. 

When does an immediate annuity begin making payments?

While immediate annuity plans differ, payments can begin as soon as 30 days following the initial lump sum deposit. In some cases, this timeline can expand to one year. 

Are immediate annuities taxable?

Immediate annuity payments can be taxable, depending on how the annuity was funded. 

If you used pre-tax dollars (as with a qualified plan), the entire payment is generally taxed at your ordinary income rate. But annuities purchased with after-tax funds (a non-qualified annuity) can only be taxed on gains.

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This communication is for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice.