Editors' pick: Originally published Nov. 15.
Regardless of what type of annuity you choose to provide a guaranteed lifetime income stream, the payout and benefit proposition are always the same.
All annuity income is return of principal plus interest.
Whether you buy 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 combination of return of principal plus interest.
I know that I just undercut a ton of "too good to be true" sales pitches, but this is the annuity contractual fact. Variable and indexed annuity promoters want you to believe their non-guaranteed growth promises will "offset" the income taken out, but that's long-term nonsense that never pans out. The contractual reality is that when you turn on an annuity income stream, your account value is going to go down.
This reduction somewhat irrelevant because the carrier is responsible for paying regardless of how long you live. That's why you own the annuity in the first place!
You have two annuity income choices: annuitization or withdrawal.
Depending on the type of annuity you choose, the guaranteed income stream can be structured using either annuitization or the withdrawal method.
SPIAs, DIAs, and QLACs are all "annuitized" strategies. SPIAs and DIAs used in a non-IRA account can provide a significant tax benefit because the return of principal part of the income is not taxed. Only the interest portion is subject to taxation. Annuitization is akin to ripping the knob off a water faucet. Once you do that, the water is going to flow. This correlation applies to an annuitized income stream. Once you start the lifetime payments (i.e. "annuitize"), only your death will stop the money from hitting your bank account.
Most Income Riders available use a guaranteed withdrawal method instead of annuitization. By the way, "withdrawal" means subtraction, and your income amount is deducted in full from your annuity contract every time you receive a payment. The income stream is taxed "LIFO" (Last In, First Out) using a withdrawal strategy, which means gains are taxed first at ordinary income tax levels.
Taxation depends on the type of account.
Annuities can be purchased inside of a Traditional IRA, Roth IRA, some selected employee sponsored retirement plans, and non-qualified (non-IRA) accounts. If purchased inside of an IRA or qualified account, then the taxation of the annuity income is determined by those specific IRA rules.
Non-qualified (non-IRA) accounts will have only the interest or gains taxed at ordinary income levels, and those taxes will be determined by what type of annuity income strategy (annuitization or withdrawal) is chosen.
Zero is your annuity income hero.
With any type of guaranteed annuity lifetime income stream, there is no way to determine ROI (Return on Investment) until you die. Up until that point, it is a pure transfer of risk. This factual annuity statement drives stock market investors crazy, but is the reason that annuities should never be considered as investments. They are contracts. Pure and simple.
The goal of all annuity income strategies is to draw your account down to zero as soon as possible, so you can be in the annuity company's pocket. Up until that point, you are getting your own money back with interest. This important point is hard to fully grasp for a lot of people, but is crucial to fully understand because this is the true value proposition of annuity lifetime income guarantees.
You want to transfer the risk to the annuity company to pay you regardless of how long you live, and they are on the hook to pay even if your account shows $0.
Lifetime income is unique only to annuities.
Bonds are great. CDs are fantastic. Dividend stocks are pro-customer. However, annuities are the only financial product on the planet that contractually guarantees a lifetime income stream regardless of how long you live. Since the Romans first developed and used Single Premium Immediate Annuities (SPIAs) for their Roman soldiers, annuities have been the only income strategy that completely solves for longevity risk.
For some reason, the annuity industry has chosen not to promote this unique benefit that most Americans need. Business schools will one day study this lack of leadership and vision as one of the biggest marketing mistakes ever in the financial services industry.
It's all about the highest contractual guarantee.
Annuities are commodity products, regardless of type. In other words, you must constantly shop all carriers for the highest contractual guarantee for your specific situation. Annuity carriers hate when I point out this fact because it destroys the "ours is better" sales pitch. But contractual facts are annuity facts, and the consumer needs to know that annuities are commodities.
When you shop for plane tickets, most of us go to sites like Orbitz, Expedia, or Kayak to find the best price. The same strategy must be applied when looking for the highest contractual guarantee.
Three steps to choosing your income stream
Shop all carriers for the highest contractual guarantee
Decide whether an IRA or non-IRA account will house the annuity
Analyze the taxation of the income (IRA or non-IRA)
Buying an annuity to solve for lifetime income is that simple.
This article is commentary by an independent contributor. Stan The Annuity Man is the top independent annuity agent in the country, licensed in all 50 states, and a co-founder of Annuities.direct, the first direct to consumer annuity shopping platform.
Stan The Annuity Man has published six best-selling books on annuities, and will send them as a gift to all TheStreet readers under no cost or obligation. Simply email Stan (email@example.com) your physical mailing address or click to fill out the online form.