Laura answers a listener’s question about whether a single premium immediate annuity (SPIA) is right for her mother’s retirement portfolio.
Laura answers a listener’s question about whether a single premium immediate annuity (SPIA) is right for her mother’s retirement portfolio.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
Have a money question? Send an email to money@quickanddirtytips.com or leave a voicemail at 302-365-0308.
Find Money Girl on Facebook and Twitter, or subscribe to the newsletter for more personal finance tips.
Money Girl is a part of Quick and Dirty Tips.
Links:
https://www.quickanddirtytips.com/
https://www.quickanddirtytips.com/money-girl-newsletter
https://www.facebook.com/MoneyGirlQDT
https://twitter.com/LauraAdams
Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Emily O., who says:
“I’ve been listening to the Money Girl Podcast for about five years and always learn so much. It makes my commute home so much more exciting!
My mom is 78, very healthy, and lives independently. She receives $1,000 monthly from Social Security and has a retirement account balance of about $420,000. Her financial advisor brought up the idea of buying a single premium immediate annuity. It might cost from $130,000 to $200,000 and would pay in the range of $1,000 to $1,400 monthly. What are your thoughts on annuities and would you recommend one for someone in my mother’s situation?”
Thanks for your kind words and great question, Emily! This post will review what a single premium immediate annuity is, how it works, its pros and cons, and who should consider buying one.
Welcome back, everyone, and thanks for joining me. I'm Laura Adams, an award-winning author, finance spokesperson, money speaker, founder of The Money Stack newsletter, and host of the Money Girl podcast with 43 million downloads. My mission is to help you get the knowledge and motivation to prioritize your finances, build wealth, and have more security and less stress.
Be sure to follow Money Girl on Apple Podcasts, Spotify, or wherever you listen to podcasts so you automatically get each new episode! If you have a question you'd like me to cover, please leave it on our voicemail line at 302-364-0308. You can send an email and sign up for the free Money Stack newsletter at LauraDAdams.com.
What is an annuity?
Before we discuss the specifics of a single premium immediate annuity or SPIA, let’s review annuity basics. An annuity is a contract between you and an insurance company that guarantees certain financial benefits, such as never running out of money in retirement. They’re sold by licensed professionals through insurance companies, banks, brokerages, and financial advisory firms.
Since fewer Americans qualify for a lifetime pension from an employer, an annuity can complement your retirement savings and Social Security retirement benefits. In fact, Social Security is the ultimate annuity because it pays qualified recipients a lifetime, inflation-adjusted, monthly retirement benefit guaranteed by the federal government.
But what if you retire and need more income? Or, you’re afraid of outliving your modest savings, concerned about inflation, worried about your future cognitive health, or expect to live a really long time? In those situations, an annuity can be an excellent solution.
LISTEN ALSO: When should you buy an annuity for retirement?
What are the main types of annuities?
There are two main types of annuities based on how you fund them: flexible premium and single premium.
Flexible premium annuities allow you to add funds over time, such as monthly, quarterly, or annually, according to any schedule you wish.
Single premium annuities require you to make a one-time, lump sum payment.
With either a flexible or single premium annuity you can choose to begin getting paid an income right away or in the future. An immediate annuity starts an income stream as soon as one month after your contract’s issue date.
A deferred annuity allows you to begin receiving income at a future date. The payout doesn't begin for at least a year after your last premium payment but may be deferred by up to 40 years.
What is an annuity rider?
When you shop for an annuity, you’ll find various customized options, known as riders, that give you additional benefits for an added cost. A few rider examples include:
Death benefit - ensures that your beneficiary receives any annuity balance after your death.
Long-term care - increases your annuity payments to cover costs for care at home or in a nursing facility.
Terminal illness - allows you to access some or all of your annuity balance without paying early surrender penalties if you're diagnosed with an illness that gives you a shortened life expectancy.
Cost of living - requires your annuity payments to keep pace with inflation up to a preset cap.
How does a single premium immediate annuity (SPIA) work?
A SPIA is one of the most simple types of annuities. You agree to pay an insurer an upfront lump sum, which is the single premium. In return, the annuity provider agrees to pay you an immediate stream of income, known as annuitization.
The series of payments you receive from a SPIA could be for a specified period, or the rest of your life, depending on the option you choose. As I mentioned, your payments can be fixed or adjusted annually, such as for inflation. You’ll have a guaranteed income stream no matter what happens in the financial markets.
Emily mentioned that her 78-year-old mother could buy a SPIA from $130,000 to $200,000 that would pay her from $1,000 to $1,400 monthly for life. The income you receive from an annuity depends on your age, gender, home state, and the interest rate when you buy it.
Suppose Emily’s mom purchased the same annuity 18 years ago when she was 60. In that case, she would have had a longer life expectancy and the annuity would have paid her less. Or, if she had a shorter life expectancy due to a terminal illness, the same annuity would pay her more.
So, think of an annuity as the opposite of life insurance. With a life policy, insurers charge older people more because they’re more likely to die, triggering a payout to the insured’s beneficiary. With an annuity, insurers guarantee higher annuitization payments to older people because they’re likely to die sooner rather than later.
How do taxes work on a single premium immediate annuity (SPIA)?
Emily mentioned that her mom’s money is in a retirement account. You can purchase any type of annuity using money inside or outside of a qualified retirement account, such as an IRA.
When you own an annuity outside of a retirement account, it's called a non-qualified annuity. You must pay a non-qualified SPIA premium on an after-tax basis. Your payments will be made up of principal, which is tax-free, and investment earnings, which gets taxed as ordinary income.
Owning an annuity inside a retirement account is called a qualified annuity. That means it’s subject to the retirement account rules. For instance, owning a SPIA in a pre-tax, traditional IRA means your premium is tax-deductible but your payments are taxed as ordinary income.
You can also own a SPIA in an after-tax, Roth IRA. In that case, your premium would be paid on an after-tax basis and your income payments would be entirely tax-free.
What are the pros of a single premium immediate annuity (SPIA)?
A significant pro of buying a SPIA is that you shift a portion of investment risk to the annuity provider. As I mentioned, no matter what happens in the financial markets, the annuity company is contractually obligated to pay you a guaranteed income. Therefore, instead of having to invest the single premium amount yourself, in a potentially volatile financial market, you purchase an income stream.
Turning a portion of your savings into secure, lifetime income from an annuity doesn’t mean you’ll get the highest possible return on your investment. But it means you no longer need to be concerned about investing that portion of your portfolio.
In addition, if you have a long life, the annuitized income payments could add up to be greater than the single premium you paid to purchase a SPIA.
What are the cons of a single premium immediate annuity (SPIA)?
Of course, every financial product also has downsides. A con of buying a SPIA is that you agree to pay money to an annuity provider that you typically can’t get back without paying a significant penalty. That could be a problem if you suddenly need the cash for healthcare or long-term care expenses–unless you purchased a long-term care rider.
Buying an annuity may also mean you leave a smaller inheritance to your heirs. Remember that you (or your heirs) don’t get the single premium back unless you choose a product with a death benefit.
Plus, if you die sooner than expected, the single annuity premium could be much larger than the income stream you receive while you’re alive. However, by purchasing an add-on, such as a death benefit, you could ensure your estate doesn't lose money on a SPIA.
Also, as I mentioned, you may not receive a return on a SPIA that’s as high as other investment options. You must be willing to give up control of your funds in exchange for a certain amount of guaranteed income.
Who should buy a single premium immediate annuity (SPIA)?
With stock market investments, you may receive higher returns than an annuity, but they’re never guaranteed. So, owning one or more annuities ensures you survive a long retirement even if the market drops.
Emily’s mom is likely a good candidate for a SPIA based on having a fairly modest savings and Social Security income. If she’s worried about outliving her money, SPIA payments can give her a monthly check and perhaps a more comfortable retirement no matter how long she lives.
As I mentioned, if you buy an annuity and live a long life, you'll get a great bargain. But if you live a short time after annuitizing, the annuity provider wins, unless you opt for a death benefit rider.
Annuities can be a terrific addition to your portfolio if you want the simplicity and peace of mind of additional guaranteed monthly income. But since there’s a lot to consider, including taxes, estate planning, and various riders, please consult a qualified financial advisor about whether a SPIA or any other type of annuity fits your retirement strategy.
Carefully review the pros and cons of different annuities and riders with your advisor, and consider getting a second or third opinion if you're unsure about the annuity type or amount that's best for your needs.
Be sure to follow Money Girl on Apple Podcasts, Spotify, or wherever you listen to podcasts so you automatically get each new weekly episode!
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
Money Girl is a Quick and Dirty Tips podcast, and I want to thank our fantastic team! Steve Riekeberg audio engineers the show. Our Director of Podcasts is Brannan Goetschius, our digital operations specialist is Holly Hutchings, our advertising operations specialist is Morgan Christianson, and our marketing and publicity associate is Davina Tomlin.