What is annuity income and how can it bridge your retirement gap?
Retiring early is the dream of millions of workers. Others end their careers unexpectedly and prematurely due to a late-career layoff, health problems, or other issues.
Whatever the reason, leaving work behind in your 50s and early 60s can create a host of financial challenges — especially true if you are not yet 62, and thus not eligible for Social Security.
Fortunately, there is a potential financial fix for some early retirees who need additional income.
Annuity payments can provide you with a steady stream of guaranteed payments. This can help you bridge the gap between the end of work and your first Social Security payment.
This approach can reduce exposure to market volatility during a critical transition period.
Learn more about what annuities are and how they work. Find out how you can use this financial tool to help make ends meet during early retirement.
What is annuity income? The basics explained
An annuity is a contract you create with an insurance company in exchange for regular income payments during your retirement.
The purchaser of an annuity provides the insurance company with a lump sum or a series of regular payments over time. In turn, the insurer agrees to make regular, predetermined payments to the annuitant.
For example, a $100,000 annuity might generate over $1,000 in monthly income, depending on factors such as age, payout structure, and interest rates. You can estimate potential payments using our annuity calculator.
The income stream from an annuity continues for a predetermined period — sometimes for life.
With an annuity, your income is typically guaranteed to remain unchanged during the agreed-upon period, regardless of market performance.
By contrast, retirement accounts such as IRAs and 401(k) plans are often subject to market fluctuations.
The fact that annuity payments are guaranteed brings great peace of mind to many retirees, helping them to feel secure that they will not outlive their savings. However, the income you receive from an annuity may be lower than what you could potentially earn through investments such as stocks and bonds.
Types of annuities and how they generate income
Many different types of annuities are available that might help you bridge your retirement income gap.
Immediate vs. deferred annuities
Immediate annuities begin payments within one year of purchase. Unlike other types of annuities, there is no accumulation phase. These annuities often make the best sense for those who can pay with a lump sum and who want their income payments to begin right away.
Deferred annuities allow you to gradually build value on a tax-deferred basis before payments begin, typically after at least one year.
Once income payments begin, withdrawals are taxed as income.
A deferred annuity is suitable for those who are still in their career but would like to use their working years to build a future retirement income.
Fixed, variable, and indexed annuities
- Fixed-rate annuities allow you to pay a lump sum and receive payments based on an interest rate that is guaranteed for a time. Once this period expires, you can renew the annuity, cash it out, or exchange it for another annuity.
- Variable rate annuities are often tied to investments and have returns that fluctuate with the market. Although they do not provide the safety and consistency of fixed-rate annuity payments, variable annuities do offer the potential for greater gains.
- Indexed annuities have returns that typically are closely tied to those of a stock market index, such as the Standard & Poor’s 500 index.
Annuities often come with additional costs. Many annuities carry annual fees such as mortality charges, administrative costs, and fund expenses. These extra expenses can top 3% for a typical contract owner.
Both fixed and variable annuities may have surrender charges for a period, often up to 10 years. These fees apply to early withdrawals.
Using annuity income for early retirement scenarios
Some people retire early by choice, while others are forced into it due to health or job loss.
In either case, retiring early can increase the risk that you will not have enough cash to meet your daily expenses.
An annuity can help reduce this danger by offering a steady stream of income that early retirees can tap into to pay bills or cover other expenses.
The early retirement income gap challenge
Those who retire early generally will not be eligible to collect Social Security payments until they turn 62. This can mean anywhere from a couple of years to a decade or more of retirement without this income stream.
If early retirement is planned, this gap can be managed. But if you are forced into an early retirement suddenly, you might scramble to find sources of income that can help you cover expenses.
How annuities bridge the gap
An early retiree who purchases the right type of annuity might be better able to bridge the final gap that occurs between the last paycheck from a job and the first Social Security payment.
Buying an immediate annuity early in retirement – for example, between the ages of 60 and 62 – can provide you with enough monthly income until you achieve eligibility for Social Security benefits. You might even use such an annuity to delay claiming Social Security benefits until the age of 67 or 70, so you can maximize potential benefits.
For example, a 60-year-old with $250,000 available might purchase an eight- to 10-year immediate annuity that provides $2,200 in monthly income. This could provide guaranteed income until sometime between the ages of 68 and 70, when the retiree would finally claim Social Security and receive a bigger monthly payout for the rest of his or her life.
The Social Security Administration says benefits increase up to 8% annually for each year you delay claiming between full retirement age (generally, age 67 for most Americans) and 70.
In fact, a $2,000 monthly benefit at 67 grows to $2,480 if you wait until age 70 to claim it.
Some early retirees might use an annuity to cover essential expenses such as housing, health care, and food. With those important costs covered, they could then turn to their portfolio withdrawals to fund discretionary spending.
Those with smaller lump sums might use a strategy of partial annuitization, using 25% to 40% of retirement assets for annuities while keeping the rest invested.
How annuities fit into a broader retirement strategy
The key to using annuities effectively is understanding how they complement other income sources.
The safe, steady stream of income you earn from an annuity can provide you with more flexibility in making withdrawals from your portfolio of stocks and bonds. Annuity income might provide you with the funds you need to avoid dipping into a 401(k) plan at times when the stock market is declining, for example.
You might also be able to combine annuity income with income from a part-time job, side hustle, or consulting income. This can provide you with enough cash to easily cover your bills and discretionary expenses.
It’s even possible that an annuity will offer you the income you need to pay for daily expenses while you convert money from a traditional IRA into a Roth IRA.
When annuity income makes sense for early retirement
Annuity income is one tool that can help create stability during early retirement. Whether you choose to retire early or are forced to do so, annuities can provide the money you require to cover wants and needs as you wait to file for Social Security benefits.
For many early retirees, the best approach is to combine sources of guaranteed income – such as annuities and Social Security – with portfolio withdrawals so they will have enough monthly income to enjoy decades of their golden years with a sense of financial freedom.
Next steps:
1. Calculate essential monthly expenses that require a guaranteed income
2. Go to the Social Security Administration website to estimate benefits at different claiming ages
3. Evaluate whether your income gap exists and how large it may be
4. Request annuity quotes from multiple providers
5. Consider consulting with a financial advisor before deciding
