What’s a deferred annuity?

Annuities are long-term investments that are designed to give annuity owners a guaranteed income in retirement. Generally, you may be required to make a lump sum payment or an initial payment plus periodic premiums to purchase an annuity. Annuity providers may offer several types of annuity products, each for a different purpose. One of these types of annuities is a deferred annuity.

A deferred annuity is a type of annuity that pays a regular income or a lump sum payment at a specific date in the future. It has two phases i.e. accumulation and distribution phase. During the accumulation phase, you contribute to the annuity, and the money grows tax-deferred. During the distribution phase, you can make regular withdrawals or take a lump sum distribution.  

How deferred annuity works

A deferred annuity is similar to other types of annuities, where you transfer money at once or in smaller amounts over several months or years. The annuity provider invests the money according to the investment strategy you choose. During this period, the annuity is in the accumulation phase where the money grows on a tax-deferred basis. You won’t pay taxes on the annuity earnings until when you receive payments in retirement.

During the distribution phase, you can start receiving regular income or take a lump sum payment from the annuity. You can choose to spread payments over a set period of time such as 20 years, or opt to receive annuity payments for the rest of your life. The amount you receive depends on the terms of the annuity and how long you made payments to the annuity plan.

Types of deferred annuities

Fixed deferred annuities

A fixed deferred annuity has a guaranteed rate of return, and you know the amount you will receive in retirement. The rate of return is often lower than the market returns, but it provides certainty that your money will grow by a certain amount. However, it does not adjust payments for inflation.

Variable deferred annuities

When you purchase a variable deferred annuity, you won’t receive a guaranteed rate of return. Your savings are invested in sub-accounts, which hold various types of assets like stocks, bonds, and money market accounts.

Typically, the return on your investments depends on the investment’s performance. If the investments perform well, your annuity balance will grow and increase your future payout. However, if the investments underperform, your annuity balance won’t grow as much, and you may receive reduced payouts.

When you purchase a variable annuity, you take up more risk than other types of annuities since there is a potential to lose money. However, it also provides an opportunity to grow your savings more than other types of deferred annuities.

Index deferred annuities

An index deferred annuity is tied to a market index. When the index performs well, you earn higher returns, while if the market performs poorly, you can expect to earn less. This makes an index deferred annuity similar to a variable deferred annuity, but they differ in one aspect- the index annuity sets a limit on the highest possible losses and gains. Also, you are guaranteed not to lose your savings amount.

Payout options for a deferred annuity

Once the deferred annuity reaches the distribution phase of its contract, you can start receiving payouts in several ways.

Lifetime deferred annuities

You can opt to receive distributions over your lifetime. This means that you will continue receiving payments until your death, regardless of how long you live. However, once you die, the annuity payments will stop, and no further payments will be paid to your family unless you purchase an extra rider.

Fixed-period deferred annuities

Fixed-period annuities are paid over a specified period. For example, you can choose to receive payments over a 20-year period. If this period lapses when you are still alive, you won't receive further payments. On the other hand, if you pass away during the payment period, the annuity provider will continue making payments to a named beneficiary.

Lump-sum

If you prefer a single payment, you can choose to receive the distributions in a single taxable payment. You won’t receive further payments.

Pros of deferred annuities

Guaranteed future income

When you purchase a deferred annuity, you are essentially building your savings for a guaranteed income later. The future payments can help you pay your retirement expenses, and provide an additional income alongside any Social Security benefits and pension payments you receive.

No maximum limits

Unlike 401(k) and IRAs which have an annual limit on how much you can contribute, a deferred annuity does not have a maximum contribution limit. This can be a significant advantage to high earners who have maxed out their retirement account contributions and still want to create additional future payments.

Tax deferral

If your investments earn returns during the accumulation phase, you won't pay taxes on the earnings until when you take a distribution. Tax deferral allows your annuity earnings to grow through compounding, and you will only pay income taxes when you receive payouts. Also, if your estate or beneficiaries receive death benefits from the annuity provider, they will pay federal income taxes on these payouts.

Extra rider benefits

When you purchase a deferred annuity, you can buy extra riders to get additional benefits. Some of these riders include death benefits, guaranteed minimum payment, return of premium, and long-term care rider.

Cons of deferred annuities

Here are some of the drawbacks of deferred annuities:

Poor liquidity

Once you purchase an annuity, it is nearly impossible to get your money back during the accumulation phase. You will pay high costs such as surrender charges if you terminate the annuity contract before the surrender period lapses.

High fees

An annuity promises to pay a guaranteed income in retirement, but this benefit comes at a cost. You can expect to pay various fees on your investments, including underwriting fees and sales commissions, which can range from 5% to 7% of the total annuity value.

Early withdrawal taxes

If you make an early withdrawal before age 59 ½, you will owe a 10% early withdrawal penalty in addition to the regular federal income taxes. Generally, the IRS wants annuity owners to keep their money in the annuity to benefit from the tax advantages.