Immediate Payment Annuity

Written By
Paul Tracy
Updated July 31, 2021

What is Immediate Payment Annuity?

Immediate payment annuities (also called single-premium immediate annuities or SPIAs) are annuities that begin making payments to the owner immediately (within one year of purchase).

How Does Immediate Payment Annuity Work?

An annuity is a contract whereby an investor makes a lump-sum payment to an insurance company, bank or other financial institution that in return agrees to give the investor either a higher lump-sum payment in the future or a series of guaranteed payments.

The typical annuity investor begins receiving payments after the surrender period expires and the investor is at least 59 1/2 years old. But immediate annuities have little or no surrender period. That means the owner begins receiving payments as soon as he purchases the annuity and continues to receive them until he dies.

To understand how this works, let's assume you'd like guaranteed monthly payments of $1,000 every month for as long as you live now that you've retired. The insurance company may require you to deposit, say, $100,000 now to obtain an immediate annuity that guarantees that desired future stream of income, and the payments will begin flowing to you within a year. In the real world, the size of the original investment, the contractual terms of the annuity and interest rates determine the monthly payment. Unlike IRAs, there are no restrictions on how much an investor can put into an annuity.

It is important to note that a portion of the monthly payments from SPIAs not held in retirement accounts is considered a return of principal and is not taxable. Immediate annuities also do not incur a 10% IRS penalty if the owner makes withdrawals before age 59 1/2.

Most annuity payments cease upon the death of the annuitant, and the insurance company keeps whatever is left over. Thus, the size of an annuity's monthly payments are also a reflection of the bet the insurance company essentially makes regarding whether the annuitant will die before the annuity is fully paid out. However, some insurance companies offer life-plus-five or life-plus-ten options, whereby the annuity payments go to the owner's beneficiary for five or ten years after the owner's death.

Why Does Immediate Payment Annuity Matter?

Recent retirees and investors who can afford to give up access to their principal and want guaranteed monthly income and tax benefits and are in a high-interest rate environment are optimal SPIA investors.

Wise investors must consider some important drawbacks to annuities in general. For one, the taxable portion of payments from immediate annuities is usually taxable at the owner's ordinary income tax rate (rather than the lower long-term capital gains rate). Further, when a beneficiary inherits an annuity, he or she is taxed on the annuity's gains at the ordinary tax rate instead of getting a step-up in basis as would be the case if he or she had inherited mutual fund shares.

Unlike bank deposits, the FDIC or other agencies do not insure annuities, and if the issuer goes bankrupt, an annuity can lose some or all of its value. Therefore, it is important to consider the creditworthiness of an issuer when shopping for an annuity. Best's Rating Service, Moody's and Standard & Poor's all provide this service.

Fees are also major source of controversy for annuities. There are often front-end loads, state taxes, annual fees based on a percentage of the account value, early withdrawal penalties, etc., and they may offset much or all of an annuity’s tax advantages. Pressuring sales tactics and less-than-transparent disclosure have also tarnished the image of annuities, so wise investors should be sure to read these disclosure materials and ask his or her financial consultant plenty of questions.

Although immediate annuities (an annuities in general) are controversial, they may be good bets for some income investors. Ultimately, the appropriateness of an immediate annuity is dependent on the investor's financial goals, tax situation and the types of annuities available. Inflation and interest rate expectations may affect the type of annuity an investor chooses, as will the investor's wishes for his or her dependents and heirs.

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