How to Choose Your Annuity Payout Option

Selecting how you’ll receive income from your annuity is one of the most important financial decisions you’ll make in retirement. The payout option you choose determines not only how much you’ll receive each month, but also how long those payments will last, and whether any funds will go to your beneficiaries after you’re gone. From lifetime income to fixed-period payments and joint annuities for couples, each option comes with its own balance of security, flexibility and legacy planning.

You may even want to take advantage of the experience of a financial advisor as you make these critical decisions. Doing so could be especially beneficial for your long-term retirement plans.

Immediate vs. Deferred Annuities

There are two primary types of annuities: immediate and deferred. Immediate annuities start distributing monthly income right after you buy it. Deferred annuities receive one or more deposits and let the money grow tax-deferred over time. At some point in the future, the owner of the annuity will decide to start taking withdrawals.

Both types of annuities have decisions to make about their annuity payout options. Deferred annuities have more annuity options than immediate annuities because once you’ve annuitized your account, you cannot change your decision. Therefore, making an informed decision is incredibly important during this time.

Annuity Payout Options

The three most common annuity payout options are annuitization, systematic withdrawal and lump sum distribution. However, there are additional annuity payout options that are variations upon these basic strategies. Here’s a breakdown of each choice:

1. Single Life and Life-Only

This option provides the highest monthly payout of any annuity payout option. The entire account balance is converted into a stream of payments that will last for the rest of the account owner’s lifetime. This option ensures that the account owner will always have a monthly payout, no matter how long they live. The downside is that if the owner dies relatively quickly, their beneficiaries are left with nothing.

2. Life Annuity With Period Certain

A period certain annuity option guarantees that the annuity will provide monthly income for a minimum number of years, even if you pass away before then. This choice does reduce the monthly payment, but it addresses the concern of passing away too quickly after choosing the option.

3. Joint and Survivor Annuity

The joint and survivor annuity option is typical for couples who want to ensure that the surviving spouse will continue to receive payments after the other spouse dies. Depending on the contract, the surviving spouse may receive the full payment or a lower percentage. This could typically be 50% or 75% of the original amount.

4. Lump Sum Payment

A lump sum payment enables the owner of the annuity to cash out the annuity and takes all of the money immediately. While this does offer the investor more flexibility, this increases the chance of the money running out before they pass away.

Additionally, this option can result in a larger tax bill for the annuity’s growth. This should come as no surprise, considering the IRS will hit you harder as your taxable income for the year piles up.

5. Systematic Annuity Withdrawal

This method is similar to annuitization, but it does not guarantee lifetime income. Instead, the investor makes automated withdrawals of a certain amount on a fixed schedule, which can result in them running out of money before the end of their life.

6. Penalty-Free Withdrawals

During the early years of an annuity, the insurance company will likely charge a surrender fee on the amount withdrawn. Surrender fees usually apply during the first six-to-eight years. They can start out high and typically decrease each year until they are fully eliminated. Some annuities allow a penalty-free withdrawal of up to 10% of the annuity’s value, which avoids these fees altogether.

Which Annuity Payout Options Are Best?

The best annuity payout options depend on your personal situation and your goals. With multiple strategies to choose from, annuities can be a valuable tool in your retirement income planning. Here are a couple of scenarios where the account holder may choose a different option than traditional annuitization:

Being in Bad Health: Someone in bad health may choose to make periodic withdrawals or a life annuity with a period certain. The periodic withdrawals will keep the remainder of the balance available for beneficiaries. Period certain annuitization ensures that payments are made every month for a minimum period of time, even if the original account holder passes away first.
Spouse Has Limited Retirement Savings: The joint and survivor annuity option is chosen when a spouse wants to ensure that their spouse will continue to receive annuity payments, even if they pass away first. This option is ideal when one spouse worked outside the home and has the majority of the retirement assets in their name.

There’s no single “best” annuity payout option. The right choice depends on your personal needs, income goals and family situation. If your top priority is ensuring that you never outlive your money, a life-only payout may offer the highest monthly income. However, if leaving something for your spouse or heirs is important, other payout options provide more flexibility and protection.

How Are Annuity Distributions Taxed?

One of the key benefits of an annuity is tax-deferred growth. This means that any earnings inside your annuity, whether from interest, dividends or investment gains, aren’t taxed until you start taking withdrawals. Deferring taxes allows your money to compound more efficiently over time, helping you build a larger balance before retirement.

When you begin taking distributions from your annuity, those withdrawals are typically taxed as ordinary income rather than at the lower capital gains rate. The exact amount subject to tax depends on whether your annuity was funded with pre-tax or after-tax dollars. If you purchased the annuity with pre-tax funds, such as through a traditional IRA or 401(k) rollover, your entire distribution is taxable. If you used after-tax dollars, only the earnings portion of each withdrawal is taxed.

For non-qualified annuities funded with after-tax money, the IRS uses what’s known as the exclusion ratio to determine the taxable portion of each payment. Essentially, part of your distribution is considered a return of your principal (and therefore tax-free), while the rest represents taxable earnings. Once you’ve fully recovered your original investment, any remaining payments are fully taxable as ordinary income.

Bottom Line

Annuities provide a valuable source of retirement income that you cannot outlive. As an annuity buyer, you have many choices when it comes to your annuity payout options. Once your account becomes annuitized and you start receiving monthly payments, the decision cannot be reversed. It makes sense to explore all of your options and discuss them with a professional to ensure that you understand the pros and cons of each.

Tips for Annuity Investors

With so many annuity payout options to choose from, it can be a challenge to know which one is right for you. Financial advisors can offer impartial advice to match you with the right strategies. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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