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Understanding Annuity Income

piggy-bank-1056615_640There are a lot of choices when purchasing an annuity, but in general, the guaranteed  lifetime income stream is always the same, according to a recent article from The Street. Author, Stan “the Annuity Man” Haithcock, argues that whether you purchase an SPIA (Single Premium Immediate Annuity), DIA (Deferred Income Annuity), QLAC (Qualified Longevity Annuity Contract), or attach an Income Rider to a Variable or Indexed annuity, all income from an annuity is a mixture of return of principal and interest.

There are two ways to receive your guaranteed income stream depending on the type of annuity you purchase: annuitization or the withdrawal method. SPIAs, DIAs, and QLACs are “annuitized” strategies. When used in a non-IRA account, SPIAs and DIAs can provide a noteworthy tax benefit, as the return of principal is not taxed, just the interest. Once you “annuitize,” or start the lifetime payments, they will only stop upon your passing.

A large percentage of Income Riders use a guaranteed withdrawal method instead of annuitization.  This means that when you receive a payment, your income amount is deducted from the annuity contract. The income stream is taxed “LIFO” (Last In, First Out), meaning that gains are taxed first at ordinary income tax levels.

Taxation of your annuity depends on the type of account it is purchased in. Options include a Traditional IRA, Roth IRA, some employee sponsored retirement plans, and non-qualified (non-IRA) accounts. If bought inside an IRA or qualified account, the taxation is determined by the specific IRA rules.  Only the interest or gains in a  non-qualified (non-IRA) account will be taxed, which will be determined by what type of annuity income strategy (annuitization or withdrawal) is chosen.

There is no way to figure out the ROI (Return on Investment) on any type of annuity until you pass on. Annuity products are simply contracts that transfer risk, and they should never be confused as investments. Your goal, as an annuity owner, is to draw your account down to zero as soon as possible so that your income payments come out of the pocket of the annuity company. Up until then, you are simply getting your own money back with interest.

Annuities are the only products that guarantee lifetime income. Other products, like bonds and CDs, definitely have their place in portfolios, but annuities are the only option that contractually guarantee a steady stream of income, regardless of how long you live. They are the only income strategy that completely solves for longevity risk.

When looking for an annuity, it is crucial to shop around.  Annuities are commodity products, so you should shop for one like you do airline tickets. Look around for the highest contractual guarantee. Then decide whether an IRA or non-IRA account will house it, and analyze the taxation of the income (IRA or non-IRA). Buying an annuity is really that simple, but as always, it’s always recommended to discuss any potential purchase with a trusted financial advisor.

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