Immediate Annuitiesí Four Whammies!

By Henry K. (Bud) Hebeler


When you select a survivorís benefit for an immediate annuity, you experience the first of  four of annuitiesí whammies. You could select an alternative where the survivor gets 100% of the deceased annuitantís payment amount, but that is not a popular choice because everyone knows that one person can live on less than two people, and everyone can see that the amount of the payments for the 100% survivor option is far less than choosing to provide a smaller amount for the survivor. Therefore, the selection usually comes down to choosing a survivor benefit of 50% or 75% or perhaps something in between. Both the annuitant and survivor soon learn that a practical choice provides much less than first imagined.

So, whatís the second whammy? Well, you might have thought about it a little and then quickly passed over it because it seems like it would be such a small amount. Thatís the effect of inflation on the most common of immediate annuities, that is, ones with fixed future payments. People forget that inflation compounds just as investments compound. With 3.5% inflation, your future dollar will only be worth one-half of todayís dollar values in twenty years. Considering that inflation of medical expenses is perhaps twice other inflation, the real value of your fixed payments might drop 75% for drugs, medical insurance, or other medical, dental, ear or eye expenses. That can be compounded by the fact that you need more medical attention as you age.

The solution to the second whammy may be to buy an inflation-adjusted annuity. I say "may be" because it may not always be the best choice. The insurance company has to insure itself in case future inflation is very high by reducing the size of the initial payments. Therefore, you might be able to do better by saving part of each payment from a fixed payment annuity and investing it to compensate for future inflation. To know which is better, you really have to make a comparison using a detailed program like "Evaluating Immediate Annuities" from

There is a third whammy for annuities purchased outside of a qualified account, e.g., annuities that are not part of an IRA or 401(k). Thatís the fact that these may have a fixed dollar or percentage amount of each payment for the tax exclusion that disappears after the entire amount of the original investment has been returned to you. This exclusion accounts for the fact that you will be getting back part of your original investment with each payment.

Theoretically, you should get back your original investment by the time you reach your life-expectancy. So, in the simplest of cases, if you wanted to invest $100,000 and the combined life-expectancy was 20 years, each year you would excuse $5,000 from income tax. ($100,000 divided by 20.) The amount of the payment in excess of $5,000 is taxed at your ordinary income tax rate until the total of your exclusions exceeds your original investment.

But what happens if you live longer than the life-expectancy? The answer is that the full amount of each payment is taxable. This is the third whammy. If you are in the 30% tax bracket, your after-tax income takes an immediate hit. It the example, that would be a $1,500 reduction in your after-tax income for all future years.

On the other hand, if you die young with any kind of immediate annuity in a non qualified account, either your survivor or heirs will experience the fourth whammy. Thatís when the survivor or heirs try to get some money back from the IRS because the full exclusion amount wasnít used or will unlikely to be used by the survivor. Accountant fees to produce the miracle of getting money back from the IRS are likely to be more than the refund. People who die young with immediate annuities leave money on the table which the insurance company picks up. If the money is in non qualified accounts, the IRS gets more than its fair share. People who live longer than average beat the insurance companies bet on life-expectancies, but the IRS never loses. The IRS only bets on sure things.

So be careful about those whammies! Then compare annuities with other alternatives.