A deferred annuity gives the customer a sum of money at some point in the future. Depending on the contract, the insurance company might pay that sum in a single payment, or it could pay out the money over a period of time, such as monthly for 25 years or for the remainder of the customer’s life.
The Benefits of a Deferred Annuity
“If a thing is worth doing, it is worth doing well. If it is worth having, it is worth waiting for. If it is worth attaining, it is worth fighting for. If it is worth experiencing, it is worth putting aside time for.” — Oscar Wilde
It can be a struggle to be patient as we live in an age of instant gratification. But, some things are absolutely better when you have to wait for them. It could be that vacation you booked a year ago, the release of a new book, album, or movie, or that bottle of bubbly you’ve been saving for a special day. And, while it may sound cheesy, the same is true with annuities — specifically, a deferred annuity.
A deferred annuity is an insurance contract that promises income at a future date. That means you can’t touch your money until the specified date that you agreed up in your contract.
But why would you want to delay accessing your money? As the J.G. Wentworth tagline used to exclaim, “It’s my money and I need it now!”
The main reason? All of the earnings on the premium grow tax-deferred. And your money will continue to accumulate until it’s withdrawn.
What’s more, a deferred annuity ensures that you’ll have a steady income throughout your golden years. And, according to the LIMRA Secure Retirement Institute, deferred annuities are forecast to have the largest growth rates over the next few years.
If you truly need your money now, then that’s something you need to consider when purchasing an annuity. You have the option to start receiving payments within a year. This is called an immediate annuity. But, if you’re financially stable for the foreseeable future, then go ahead and wait to collect your money.
Or, you might be able to have your cake and eat it too with a split-funded annuity. This strategy allows you to take advantage of the benefits of both immediate and deferred annuities.
But, for the time being, let’s dig deeper into deferred annuities to make sure that it’s something that you’re willing to wait for.
What is a Deferred Annuity?
Also referred to as a longevity annuity or deferred income annuity (DIA), a deferred annuity is guaranteed income that you purchase from an insurance company. In addition to having a tax-deferred status, this reduces the risk of your outliving your savings.
When you purchase a deferred annuity, you’re committing money today in exchange for a monthly paycheck. This money will keep flowing in as long as you’re kicking and breathing. In short, think of this as a pension that you’re bought for yourself.
Usually, you purchase a deferred annuity in one lump-sum premium. But, you may be able to make a series of payments as well. The insurance company then promises to give you a steady, guaranteed paycheck for life.
The size of your check is specified upfront and is based on factors like you’re age, gender, and premium. And, you’ll usually begin receiving these checks anywhere from 2 to 40 years after the premium was paid.
That annuity delivers two key benefits.
1. A guaranteed income.
A customer who chooses to take a deferred monthly payment for the rest of their life will know they’ll have a set amount of money coming to them each month until they die. That makes a deferred annuity a useful supplement to a pension fund.
Pensions alone are rarely enough to live on through retirement years, so buying an annuity provides another kind of income to see someone through their life after work. And if the owner of the annuity dies before receiving payouts, an heir can often inherit the account.
2. Tax deferment.
Annuities have two phases. During the accumulation phase, the customer puts money into their fund. During the payout phase, they receive their returns. The tax on the growth enjoyed by money placed in an annuity is deferred until the payout phase. At that point, the income from an annuity is taxed at the customer’s usual income tax rate.
A deferred annuity, then, functions as a kind of savings plan. It enables people to put money away for the future and know that it’s available when they stop working. But it does come with some important caveats.
Accumulation and Payout Phases
With a deferred annuity, there are two phases; the accumulation phase and the payout phase.
It’s during the accumulation phase where your annuity is accumulating interest — again, this is on a tax-deferred. It’s also during this phase when you’re making payments if you didn’t buy the annuity in a lump sum.
How does the accumulation occur? Well, this varies depending on the annuity type that you’re chosen the following.
- Fixed-Rate. Do you have a contract for a fixed annuity? If yes, your financial investment will collect interest at a fixed rate. That means that this rate will not drop below the minimum. And, it’s guaranteed by the issuing company.
- Variable Rate. What about a variable annuity contract? This permits insurers to invest your premiums in mutual funds. As a refresher, these comprise stocks, bonds, and other short-term money market products known as “subaccounts.” The rate of return you’ll receive depends on how your subaccounts are performing.
- Indexed Rate. With indexed annuities, these are also dependent on the performance of stock-market measurements. Usually, this includes Standard & Poor’s index of 500 stocks, aka the S&P 500. However, you’re also guaranteed a minimum interest rate regardless of the market.
- Death Benefits. What happens if you die during the accumulation period? With a deferred annuity, you can add a basic death benefit to your contract. This pays either some or all of the value of the annuity to your listed beneficiaries.
Remember, you don’t have to pay taxes on any of your deferred annuity earnings throughout the accumulation phase. Rather, you’ll pay taxes when you reach the payout phase. And, this does include federal income taxes and applicable state premium taxes.
Annuities Are Tightly Locked
First, annuities aren’t liquid. If you suddenly find yourself with a desperate need for extra cash, tapping into an annuity will be costly. The insurer is likely to demand surrender fees for taking out the funds, and the tax authorities will have their own demands if you pull out money before the age of 59.5. They’ll usually want 10 percent on top of the income tax rate. Don’t put your funds in an annuity unless you’re sure that you’re not going to need it until later in life.
Annuities can also be expensive.
The fees that insurance companies charge can be significantly higher for annuities than for other kinds of long-term investments. Those fees vary, though, so if you are looking for an annuity, take the time to compare the rates that different insurance companies charge. A small percentage can make a big difference when paid over decades.
And while an heir can inherit a deferred annuity during the accumulation phase, that isn’t always the case for annuities in the payout phase. Without a provision that ensures that the payout continues to an heir following the owner’s death — there is a risk that money saved in an annuity will be lost after just a payment or two.
If you’re combining a deferred annuity with payouts made over a long period, it’s worth looking into a contract’s inheritance provisions to ensure that you’re not just saving for the benefit of the insurance company.
Annuity Types By Term
A term deferred annuity will, at some point, convert your balance into a series of payments. For example, a term could be five years or 20 years. And, once the term ends, the payments cease — even if you’re alive.
Also, if you pass away before the term ends, the payments can continue to your heirs.
Lifetime Deferred Annuities
If you want your future payment to last for your entire, then you’ll want a lifetime deferred annuity. The biggest advantage of this is that you’ll never outlive your payments. In fact, the only way payments will no longer be issued is when you die.
There is a limitation to this, however. Your spouse or heirs may not be able to receive your annuity benefits after your passing. To resolve this, consider a dual life annuity. This guarantees payments for another person’s, such as your spouse’s. You could also select a death benefit that allows a portion of your annuity’s value to your heirs.
Just know that you may have to make payments for longer and even smaller monthly payments with a dual life annuity. The reason? The annuity company realizes that they’ll have to be making payments for longer.
Annuity Types By Funding: Single-Premium Deferred vs. Flexible Premium Deferred
Deferred annuities are also classified by how you pay for them. As mentioned several times above, you can make one payment or a series of payments. But, if you do make more than one payment, expect different structures.
Single-Premium Deferred Annuities
These annuities can be purchased with just one payment. However, premiums can also be spread out over a series of payments, And that’s a key difference with immediate annuities since premiums must be paid in one installment.
There are advantages and disadvantages to single premium deferred annuities. One example is that with a single premium deferred annuity, more of your money might be tied up. And, if for some reason you need to access it, you’ll have to deal with a surrender fee.
The other advantage of a single-premium deferred annuity is that you’ll receive a guaranteed rate of return and principal protection.
The downside? Those pesky surrender charges. And, there’s also a lack of capital for other investments that you might want to pursue.
Flexible-Premium Deferred Annuities
When you purchase a flexible premium annuity, you can do so through a series of payments. These payments can be scheduled as specific amounts; this is what’s known as scheduled premium deferred annuities. Or, they can change based on your ability to pay, or you’ve had to adjust your retirement savings plan.
Since you have this freedom, this type of deferred annuity has the appropriate title of flexible premium deferred annuity. And, it has additional pros like not having as much capital tied up and more time to pay for the product.
But, with every pro, there’s a con. And there might be potential contribution limits. In this case, the rate of return is not guaranteed — except with Due — with Due; you have a guaranteed 3 percent payout.
Deferred Annuity Payout Options
Once you, the annuitant, reach the distribution phase of your contract, you can receive payouts from the annuity. Typically, this begins when you reach the age of 59 ½., And, you can select the three following payout options;
- Lump-Sum. In a lump-sum disbursement, the annuity is distributed as a one-time, single payment. Just remember that this is also taxable.
- Systematic Withdrawal. With this payout option, the funds can be withdrawn or disbursed as periodic and taxable payments. If there’s any money remaining, it will continue to earn interest until your account is completely drained.
- Annuitization Under an annuitization distribution plan, you’ll receive monthly, quarterly, or yearly payments. Usually, this is for a designated amount of time or until your death.
Deferred Annuity Taxes and Withdrawals
You might have noticed that deferred annuities perform similarly to individual retirement accounts (IRAs) and 401(k)s. This is must true when it comes to taxes. Just like an IRA or 401(k), you don’t owe income taxes on anything your gain. That is until you make a withdrawal.
Once you start collecting an income, you’ll owe taxes. Until then, sit back and let your money grow. Believe it or not, this actually will happen more quickly than if you used a regular brokerage account since you’ll have to pay taxes annually.
There is, unfortunately, a major caveat. Let’s say that you wanted to make a lump sum withdrawal. Or, perhaps you decide that you want to cancel the contract. If you do either before you turn 59 ½, the IRS may charge a 10% early withdrawal penalty plus the income tax on your gains.
If you have a variable rate and your investments are performing well, your balance grows more. In turn, this increases your future payout. If your investments underperform, then your balance will not grow as much. There’s even a possibility that they could shrink. Regardless, this will reduce your future payout.
Because you could lose money that you’ve invested means that you’re taking on more risk — if you have a variable deferred annuity. At the same time, it could potentially boost your savings more so than any other type of annuity.
Adding Money to Deferred Annuities
As previously mentioned, deferred annuities have an “accumulation phase.” This is the period of time before you annuitize. But did you know that during this time, you can add funds to the account? As long as your insurance company, as well as tax laws, permit. If so, you can make a lump-sum or monthly contributions to your account,
The Benefits of Deferred Annuities
If you’re still not sold on a deferred annuity, perhaps the following advantages will change your mind.
- Tax-deferred gains. During the accumulation phase, you don’t pay taxes. Taxes only apply once the distribution phase begins and you begin receiving payments. But, if you contribute to the account with after-tax money, your contributions will come out with no additional income tax liability.
- Guarantees against loss. A bulk of deferred annuity contracts have built-in guarantees that will protect your money against loss of principal. Some may offer guaranteed rates of return.
- Lifetime benefits. As long as you annuitize your contract, the insurance company will guarantee lifetime payments for you and/or your spouse for the remainder of your lives.
- Death benefits. Deferred annuity contracts often include a death benefit element. This way, your surviving heirs will receive the assets that are left if you die before the contract ends.
- Unlimited contributions. Unlike IRAs and 401ks, the IRS hasn’t put limits on the principal amount that you can contribute to a deferred annuity.
- The power of time. When you delay your payout, your money has more time to compound. As a result, this will boost your payouts. Overall, the longer you defer your annuity, the higher the payout.
The Drawbacks of Deferred Annuities
While deferred annuities are packed with advantages, there are some drawbacks that you should be aware of.
- Complexity. A deferred annuity contract can be long, complex, and riddled with lots of small print, as with most annuities.
- Illiquid. During the first several years of your contract, you cannot withdraw any money from your annuity unless you’re willing to pay a surrender charge for making a withdrawal. Furthermore, you’ll pay a penalty to the IRS if you make a withdrawal before you’re at least 59 ½.
- High tax rates on earnings. Since annuity contracts grow on a tax-deferred basis, the IRS will tax annuity earnings at the ordinary income rate. That could be higher than the capital gains rate that’s applied to stocks, mutual funds, and exchange-traded funds.
- Additional expenses. It can be pricey to maintain a deferred annuity contract, including administrative fees, funding expenses, commissions, and charges for customized features and riders. And, thee’s also that surrender charge to be aware of as well.
Who Should Purchase a Deferred annuity?
Thanks to the guaranteed income stream, annuities sound appealing to almost everyone. They probably can fit the needs of a majority of people. But, deferred annuities are perfect if you meet the following criteria;
- You won’t be able to cover your expenses with just Social Security and/or a pension.
- You have retired early or a pre-retiree.
- You’ve accumulated between $250,000 to $5 million in savings.
- Your health is average or above-average.
- You don’t need to access your money immediately.
- You’re in the market for more of an insurance product that will provide certainty throughout your retirement.
A deferred annuity might not be the right retirement product if you’re younger than 45 and older than 75. This is also true if you’re in poor health, have under $250,000 saved, need money immediately, or don’t require a supplement income.
If you’re still hesitant about committing to a deferred annuity, consider a deferral feature with a fixed contract. This promises a minimum rate of return on your investment. As a result, this can give you some peace of mind that you’ll have a secure and stable financial future.
You could also explore a variable deferred annuity. A variable deferred annuity lets you play the investment game without assuming too much risk. Mainly because you are depositing money in stock mutual funds and may even land a minimum guaranteed income.
And, you can always dedicate a portion of your portfolio to a deferred annuity. This gives you a guaranteed future income, as well as access to your other assets if you need money for an emergency.
- What Is an Annuity?
- The Difference Immediate Annuities and Deferred Annuities
- How does an annuity work?
- The Benefits of a Deferred Annuity
- The Benefits of an Immediate Payment Annuity
- What Is a Variable Annuity?
- What Is a Fixed Index Annuity?
- What Is an Indexed Annuity?
- A Brief History of Annuities
- Will Annuities Recover?
- Money for Today or the Rest of Your Life?
- Are There Any Other Types of Annuities?
- Become Familiar With Annuity Fees
- What Are Your Payout Options?
- Weighing the Pros and Cons of Annuities
- Is An Annuity Right For You?
- How To Measure Your Annuity
- Understanding Annuity Formulas
- Annuity Calculators
- Questions To Ask Before Buying An Annuity
- Annuity Glossary Index