Understanding the earnings your money generates for you in an immediate annuity helps your evaluate your investment.

A single premium immediate fixed annuity (SPIFA) gives you a fixed monthly payment for the term of the annuity. That term may be a certain number of years or for the remainder of your life.

The amount the insurance company will pay you depends on the amount of premium you pay and prevailing interest rates in addition to expenses and your life expectancy if it’s a lifetime payout.

Companies will quote you their monthly payout to you but not the interest rate (interest rates on immediate annuities are typically 2%-4%). Nevertheless, since all earnings of the company are dependent on interest-based investments, higher prevailing rates will allow them to make higher monthly payments – and vice versa.

**Earnings and taxation of your investment**

What you earn is the excess of payouts over the premium you pay. Every payout is considered part earnings and part return of premium. The fraction of each payout that’s taxable is the ratio of the total excess payout to the premium.

To illustrate let’s take a hypothetical example of the payout over a 10 year term certain to illustrate both taxation and the effective interest that produces earnings. We’ll use the average monthly payout quote based on 16 insurance companies for a $50,000 premium for a 10 year payout term for a 70 year old man. This average quote is $515 per month. Prevailing interest rates at time of this quote are 3.30, 3.48, and 4.06 % for 1 yr, 5 yr and 10 yr US treasuries respectively.

The total payout over ten years is $61,800. So, the earnings on the premium investment is $11,800 which is the excess received over the premium paid. That’s an earnings of 23.6% (= $11,800/$50,000) –but over ten years! Of each payment, only 19% is taxable because of the way IRS taxes immediate annuities.

The example shown above is strictly hypothetical based on the assumptions described and is not representative of an investor’s actual earnings or tax consequences.

**Your effective interest rate**

Because the annuity company’s constant payout schedule returns both earnings and premium payments back to you, it can only earn interest with the premium payments it retains. In the beginning it has most all the premium to earn interest with. But this decreases linearly to no premiums left at the term’s end. Equivalently from an averaging point of view, we can consider the annuity company having only half your premium for the whole term to earn interest while the other half goes back without earnings to bolster the payouts – as is the annuity’s purpose.

So, we can deduce the “effective interest” the man earned by assuming only $25,000 (half his premium) did all the earning of the $11,800 excess payout over the 10 years. A compounded annual interest rate of 3.72% applied to $25,000 will increase it by $11,800. To see the numbers for your situation, use the immediate annuity calculator.

Note that annuities once annuitized cannot be surrendered for value. Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty. Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments.