The life income option, also known as the life annuity option, is a settlement option that allows you to receive regular payments from your retirement account for the rest of your life. This option provides a steady stream of income in retirement and protects against the risk of outliving your savings. However, there are some key considerations when electing the life income option.
What is the life income option?
The life income option, sometimes called a life annuity or lifetime income option, converts your retirement account balance into a stream of regular income payments for the rest of your life. Here’s how it works:
- You transfer all or part of your retirement account balance to an insurance company.
- In return, the insurance company promises to pay you monthly income payments for as long as you live.
- Payments are calculated based on your account balance, your life expectancy, and current interest rates.
- Payments typically start immediately or at a future date you select.
The amount of your monthly payments depends on several factors:
- Your account balance – The higher your balance, the larger your payments.
- Your age – The older you are, the higher your payments, since your remaining life expectancy is shorter.
- Payout rates – These are based on current interest rates and mortality tables.
- Payout option selected – You can choose to receive payments for your lifetime only or guarantee a minimum number of payments.
In short, you convert your retirement savings into a personal pension that lasts for life. The insurance company pools your savings with those of other annuity purchasers to fund monthly payments based on your life expectancy.
Benefits of the Life Income Option
Here are some of the key benefits of using the life income option for your retirement account:
Guaranteed income for life
The biggest advantage is that the life income option guarantees regular income payments for the rest of your life. This protects you against the risk of outliving your retirement savings, which is a major concern for many retirees. The insurance company handles the investment risks and continues payments regardless of how long you live or how markets perform.
Higher initial payout rates
Annuity payout rates are generally higher than withdrawal rates from investments you manage yourself. That’s because insurance companies can base payouts on both investment income and mortality credits. The pooled structure and risk management of annuities allows them to offer better rates.
Professional management
You hand over investment and longevity risk management to the insurance company. Their actuaries professionally manage the pooled assets to optimize risk and returns. This can provide peace of mind in retirement.
Income protection for spouse
Many annuities offer joint-life options that continue payments as long as either you or your spouse are alive. This ensures continuity of income for the surviving spouse. Income protection can be 50%, 66% or 100% of original payments.
No investment decisions or required minimum distributions
You avoid investment decisions and the need to manage retirement fund withdrawals. The insurance company handles required minimum distributions based on your life expectancy. This simplifies retirement income management.
Tax-deferred growth
When you convert a traditional 401(k) or IRA to an annuity, your savings continue tax-deferred growth. You don’t pay tax until you start receiving income payments. This allows your retirement savings to keep growing tax-free until distributions begin.
Inflation protection options
Some annuities offer optional cost-of-living adjustments to offset inflation. These periodic payment increases help maintain purchasing power over your retirement years. COLAs typically range from 1% to 4% annually.
Considerations when electing the life income option
While the life income option offers these benefits, there are some important considerations to factor in as well:
Lose access to your principal
You no longer have direct access to your savings balance. This money is now in the insurance company’s general account to fund your lifetime payments. You cannot make withdrawals or pass remaining balances to heirs (unless a certain period is guaranteed).
Locking in current interest rates
Your initial payments are set based on current annuity rates, which are tied to bond yields. If rates rise in the future, your payments will not increase. You forgo the potential to earn higher income by delaying.
Limited flexibility
Annuity payments are generally fixed and irrevocable once elected. You lose flexibility to adjust income or valuations as markets change. The only adjustments may be preset COLA increases if selected.
Solvency risk
Insurance companies issue and guarantee annuity incomes. If the insurer has financial difficulties, however, it may struggle to meet its annuity obligations. States have limited guarantees ($100,000-$500,000) to protect against insurer insolvencies.
Higher costs
Annuities involve mortality costs, administration fees, and profit margins for the insurer. These costs mean lower payouts compared to investing the money yourself. However, you benefit from transferred longevity and market risk.
Taxes on payments
If the annuity is funded with pre-tax dollars from a traditional IRA or 401(k), income payments will be fully taxable as ordinary income. This differs from tax-deferred growth investments where capital gains rates could apply.
Who might benefit from using the life income option?
Here are situations where electing the life income option could make sense:
- Retirees seeking income security – Those focused on reliable lifetime income may benefit most from annuitization.
- Individuals with shorter life expectancies – Annuity payments incorporate mortality credits. Those with poorer health can receive higher payments.
- People with significant retirement assets – Large balances allow higher annuity payment amounts that can fund essential living expenses.
- Risk-averse investors close to or in retirement – Removing market timing and investment risk may appeal most to this group.
- Those without immediate family to leave assets – If you don’t have heirs relying on your retirement balance, the loss of principal with an annuity may matter less.
In these situations, the advantage of guaranteed lifetime income security may outweigh other considerations. Your specific needs and risk tolerance should drive any decision.
Payout options to consider
Insurance companies offer various annuity payout structures to choose from:
Single life or joint life
You can elect payments over your lifetime only or over your and your spouse’s joint lifetime. Joint-life offers protection for the surviving spouse. Payments are lower than the single life option.
Guarantee period
Most annuities allow you to select a guaranteed payment period from 5-30 years. If you die before then, remaining payments go to beneficiaries. This guarantees a minimum payout regardless of life span.
Cash refund
This option pays beneficiaries the remaining annuity premium balance at the annuitant’s death if it exceeds the income payments already received. This ensures heirs receive the unused premium amount.
Cost-of-living adjustment
COLAs can increase payments from 1-4% annually to offset some inflation. However, each increase also lowers the starting payment amount. COLAs only impact remaining payments, not the full historical amount.
Death benefits
Some annuities offer enhanced death benefits if you die before reaching your life expectancy. These might return the premium paid, the account value, or greater of payments vs. premium. Additional fees often apply for this benefit.
Factors that affect payment amounts
The actual income payment you receive depends on several factors:
Age at purchase
The older you are when you buy an annuity, the larger your payments will be, all else being equal. Older individuals have shorter life expectancies, allowing the insurer to pay more per month based on fewer expected payments before death.
Account balance
The larger your annuitized account balance, the greater your monthly payments will be. With more principal to work from, the insurance company can afford larger payments per month and still meet its obligations.
Interest rates
Prevailing interest rates impact annuity payouts. Insurers base payments on investment income they expect to earn on premiums. If current rates are low, payments will be lower. Rising rates allow higher payments per month.
Market conditions
General economic and market conditions also affect monthly incomes. Insurers must preserve principal to meet future obligations. Weak markets may cause insurers to reduce payouts to protect solvency. A strong bull market can enable higher payments.
Annuity fees
Annuity fees for mortality costs, administration, and the insurer’s profit margin get deducted from income amounts. Minimizing these internal fees can result in higher payments to you.
Payout options selected
As explained above, choices like guarantee periods, spousal benefits, COLAs, and death benefits impact the amount of your basic monthly payment. More guarantees mean lower payments.
Tax treatment of annuity payments
The taxability of your annuity income payments depends on whether you funded the annuity with pre-tax or post-tax money:
Annuity funded with pre-tax dollars
Most annuities are purchased with pre-tax funds from traditional IRAs or 401(k)s. In this case, the full income payment is subject to ordinary income tax in the year received. If funded with an IRA, payments can be subject to a 10% early withdrawal penalty if taken before age 59 1/2.
Annuity funded with after-tax dollars
If you use a Roth IRA or other after-tax dollars to buy the annuity, the principal portion of payments is tax-free. Any investment earnings would be taxed as ordinary income when paid out.
Taxation of death benefits
If remaining annuity account value passes to beneficiaries upon the owner’s death, taxes depend on original funding source:
- Pre-tax-funded: Beneficiaries owe ordinary income taxes on investment gains.
- After-tax-funded: Beneficiaries receive payments tax-free.
Beneficiaries can typically take payments over time, which spreads taxes owed.
Using annuity shopping tools to compare quotes
Because annuity rates and features vary between insurers, it pays to compare quotes before you buy. Online annuity shopping tools let you quickly view quotes from multiple insurers without contacting agents.
These tools help identify insurers offering the highest fixed annuity payment amounts. You can also adjust parameters like your age, premium amount, and payout options to fit your scenario.
Benefits of using annuity shopping services:
- Obtain quotes from dozens of highly-rated insurers
- Compare monthly income payment amounts
- Identify best payout options for your needs
- Adjust parameters to optimize payments
- Focus only on top-ranked, financially strong insurers
- Save time researching individual companies
These services quickly provide an objective overview of the market so you can make an informed annuity purchase decision.
Steps for electing the life income option
Here is an overview of the basic steps to utilize the life income option for your retirement plan:
1. Evaluate your personal situation
Consider your income needs, longevity concerns, heirs, risk tolerance, and overall retirement goals. An annuity may make more sense once you’ve reviewed your full financial picture.
2. Shop annuity rates and options
Use online quotes to compare payments at different insurers. Adjust parameters to maximize income. Evaluate different payout structures.
3. Select an annuity contract
Choose the contract offering the highest secure income aligned with your preferences on payout duration, spousal benefits, COLAs, etc.
4. Transfer retirement account funds
Roll over funds from your 401(k), IRA, or other retirement account to the annuity provider to fund the contract.
5. Submit annuity application documents
Complete all required application materials and forms from the insurance company to activate the annuity contract.
6. Receive income payments
The insurance company will begin depositing guaranteed monthly income payments into your designated account per the agreed contract terms.
7. Pay applicable taxes
Be sure to pay income taxes on any pre-tax funded annuity payments you receive each year.
8. Review annually
Periodically review your annuity contract to ensure it still meets your needs as circumstances change. Seek professional advice if needed.
Pros and cons of life income option vs. systematic withdrawals
Instead of the life income option, another way to generate retirement income is taking systematic withdrawals from your investment portfolio. Here’s a comparison of the pros and cons:
Life Income Option
Pros
- Guaranteed income for life
- Higher initial payout rates
- Professional investment management
- No RMDs or required spending
- Inflation adjustment options
Cons
- Loss of principal
- Little flexibility or control
- Subject to insurance provider stability
- Higher costs than self-managing
Systematic Withdrawals
Pros
- Retain control of your assets
- Principal not forfeited if unused
- Adjustable spending and investments
- Lower costs than annuity fees
- Potentially higher long-term income
Cons
- No lifetime income guarantee
- Risk of overspending or market losses
- Complex RMD planning
- Significant investment responsibility
The better option depends on your priorities and risk tolerance. Annuities offer more security at the cost of less flexibility and higher fees.
Frequently asked questions
What happens if I take lump sum and die shortly after?
Electing a lump sum distribution and then dying shortly after means you were not able to utilize the full value of your retirement account. The lump sum option eliminates the insurance company’s future payment obligations. Any remaining balance would pass to beneficiaries per your designation.
Can I change my payment option once payments begin?
Unfortunately, annuity payment selections cannot be altered after you start receiving income payments, with the exception of certain cost-of-living adjustments. This strengthens the insurance company’s ability to offer a lifetime guarantee but limits flexibility.
What is the best age to choose the life income option?
It depends on your situation, but ages 70-75 are often ideal for maximizing income versus longevity risk protection. Waiting longer means fewer expected payments over your lifetime, allowing the insurer to pay more annually. Income needs and health outlook should guide decisions.
What happens if the insurance company fails?
If the insurer cannot meet its annuity payment obligations, state guaranty funds provide some protection. Coverage limits are $100,000-$500,000 per annuity contract depending on your state. Look for highly-rated insurers and seek state protection to manage default risk.
Can I receive a combination of lump sum and lifetime income?
Yes, most insurers allow you to annuitize only a portion of your retirement account balance. For instance, you might take a lump sum for travel spending then convert the rest for lifetime payments. This balances liquidity and income security.
Conclusion
The lifetime income option for retirement accounts uses an insurance annuity to convert savings into guaranteed income for life. While not right for everyone, it can provide peace of mind for retirees who fear outliving assets. Key considerations include loss of principal access, lack of flexibility, counterparty risk, and higher costs compared to investing yourself. Overall, the life income option warrants consideration for risk-averse individuals prioritizing retirement income security above all else.