What Is an Income Annuity and How Does It Work?

Creating a predictable stream of income can be an important part of planning for retirement.

Retirement changes the way many people think about money.

During your working years, income generally arrives on a regular schedule through a paycheck. In retirement, that paycheck may be replaced by several different sources of income, such as Social Security, pensions, retirement accounts, savings and other financial products.

One option designed specifically to provide a stream of income is an income annuity.

But what exactly is an income annuity, and how does it work?

What Is an Income Annuity?

An income annuity is an insurance product designed to convert a portion of your money into a stream of income payments.

You generally purchase the annuity from an insurance company, and in return, the insurance company provides payments according to the terms of the contract.

Depending on the type of income annuity selected, those payments may begin relatively soon or at a future date.

Income may also be structured to continue for a specific period of time or, depending on the contract and options selected, for the remainder of your life.

How Does an Income Annuity Work?

The basic concept is fairly straightforward.

You provide money to an insurance company by purchasing an annuity contract. The amount of income the contract can provide will depend on several factors, which may include:

• The amount used to purchase the annuity
• Your age when income begins
• Current interest rates and other pricing factors
• When you choose to begin receiving income
• The income option selected
• Whether the income covers one person or two
• Any additional contract features or guarantees selected

The insurance company then calculates the income payment available under the terms of the contract.

Because annuity contracts and payout options vary, two people using the same amount of money may not necessarily receive the same income.

Immediate vs. Deferred Income Annuities

One important distinction is when the income begins.

An immediate income annuity is generally designed for someone who wants income payments to begin relatively soon after purchasing the contract.

A deferred income annuity is designed for income to begin at a future date.

For example, someone may purchase an income annuity today but choose to have the income begin several years later.

The appropriate timing depends on the individual's retirement income needs, goals and the specific terms of the contract.

Can an Income Annuity Provide Income for Life?

Some income annuities offer payment options designed to provide income for the lifetime of the annuity owner.

This can help address one of the major questions people face when planning for retirement:

How do I create income that I cannot outlive?

Lifetime income options can provide payments for as long as the person covered by the contract remains alive, subject to the terms and claims-paying ability of the issuing insurance company.

There may also be options designed to provide income for the lifetimes of two people, such as spouses.

What Happens to the Money When You Purchase an Income Annuity?

This is an important question because income annuities can work differently from traditional savings or investment accounts.

When an income annuity is purchased, the premium is paid to an insurance company in exchange for the income guarantees and other benefits provided by the contract.

The amount available for withdrawals, beneficiaries or other purposes can vary considerably depending on the type of annuity and the income option selected.

Some contracts may provide death-benefit or period-certain options, while others may emphasize maximizing lifetime income.

Understanding these provisions before purchasing an income annuity is important.

What Is a Period-Certain Option?

A period-certain feature can provide payments for at least a specified number of years.

For example, a contract might provide lifetime income with a 10-year period certain. If the person receiving income dies during that initial 10-year period, payments may continue to a beneficiary for the remainder of the guaranteed period, according to the terms of the contract.

Adding guarantees or beneficiary provisions can affect the amount of income the annuity provides.

That is why comparing income options involves more than simply looking at the monthly payment.

How Is an Income Annuity Different From a Fixed Annuity?

Although both are annuities issued by insurance companies, they can serve different purposes.

A traditional fixed annuity is often used primarily to accumulate money at a stated or guaranteed interest rate for a specified period, subject to the terms of the contract.

An income annuity is designed primarily to create a stream of income.

In retirement planning, one may be used to help accumulate assets while another may be used to help turn assets into income.

Understanding the purpose of each can make it easier to determine how different financial tools may fit into an overall retirement strategy.

Where Can Income Annuities Fit Into Retirement Planning?

Retirement income usually does not come from just one source.

A retiree may receive income from Social Security, pensions, retirement accounts, savings and other sources.

An income annuity may be considered as one way to create an additional predictable income stream.

The goal is not simply to generate income, but to understand how different sources of income can work together throughout retirement.

For a broader look at this process, read CDA's Creating Retirement Income That Lasts.

Questions to Consider Before Purchasing an Income Annuity

Before purchasing any annuity, it is important to understand exactly how the contract works.

Some questions to consider include:

• When will the income payments begin?
• How much income will the contract provide?
• Is the income guaranteed for life or for a specific period?
• What happens if the annuity owner dies?
• Are there options for a spouse or beneficiary?
• What access, if any, will you have to the money after income begins?
• Are there additional features or guarantees?
• How financially strong is the issuing insurance company?

The answers can vary significantly among contracts and insurance companies.

The Bigger Picture

An income annuity is ultimately one tool for addressing a fundamental retirement question:

How will I turn the money I've accumulated into income I can use throughout retirement?

For some people, creating a predictable stream of income can provide an additional layer of certainty within a broader retirement strategy.

The important part is understanding how the income works, what guarantees are provided, what flexibility may be given up, and how the contract fits with your other retirement income sources.

At CDA of America, we believe understanding your options is an important part of making informed financial decisions.

For decades, CDA has worked with individuals, families and businesses to help them better understand insurance, retirement and financial strategies designed around their goals and priorities.

Have questions about income annuities or retirement income strategies?

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This material is provided for educational and informational purposes only and is not intended as investment, tax or legal advice. Annuity guarantees, income payments, features, withdrawal provisions, death benefits and other contract terms vary by insurance carrier and product. Guarantees are subject to the claims-paying ability of the issuing insurance company. Withdrawals or distributions may be subject to applicable taxes and other contract provisions. Consult appropriate financial, tax or legal professionals regarding your individual circumstances.