What Is a Deferred Annuity?
A deferred annuity is a financial contract that allows you to invest money now and receive guaranteed income payments in the future. Deferred annuities can be an effective tool for retirement income planning as they offer the potential for growth, tax advantages and the option for a guaranteed income stream for life.
The period of investment growth is known as the accumulation phase, and the period of income payments is known as the annuitization or payout phase. During the accumulation phase, your money grows tax-deferred, meaning you don’t have to pay taxes on your investment earnings until you start taking withdrawals during the payout phase.
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You can pursue a strategy combining the advantages of immediate and deferred annuities by purchasing a split-funded annuity.
Deferred annuities are a great and cost-effective way to make sure you don’t run out of money if you live longer than expected. If payments are set to begin near the end of your life expectancy you have a safety net in place.
Pros and Cons of Deferred Annuities
Deferred annuities have many benefits, but they may not be right for everyone. When considering purchasing any annuity, it’s important to weigh the pros and cons.
Pros
Deferred annuity owners do not pay taxes during the accumulation phase. Taxes apply once the distribution phase begins and the owner starts to receive income payments.
Most deferred annuity contracts have built-in guarantees against loss of principal and some offer guaranteed rates of return. However, loss of capital is possible with variable annuities.
Depending on how you structure your deferred annuity, it’s possible to receive guaranteed income payments for life.
Many deferred annuity contracts include a death benefit component. This ensures that any surviving heirs receive any remaining assets if you die before the end of the annuity contract.
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Unlike IRAs and 401(k)s, the IRS places no limits on the principal amount you can contribute to a deferred annuity.
Cons
Generally, annuitants are unable to withdraw any money from their annuity during the contract’s first several years unless they pay a surrender charge for withdrawals. In addition, the IRS imposes penalties for any withdrawals made before you are at least 59 ½.
Example of a Deferred Annuity
A deferred annuity makes sense for people nearing retirement or for younger investors who have maxed out their retirement plans but still want to put money into tax-deferred retirement vehicles.
Typically, annuity buyers are in their 60s. They’ve accumulated a significant amount of retirement savings and can roll that money over into annuity products without triggering adverse tax events.
If you are a younger investor, a deferred annuity allows you to accumulate wealth as you work. Then, in retirement, you can achieve a guaranteed lifetime income stream.
However, a deferred annuity limits your ability to repurpose your retirement savings and can be very difficult to reverse if you change your mind. You will have to wait for your annuity income. If you need more near-term liquidity, you may be better suited to consider an immediate annuity.
You can also consider contingent deferred annuities (CDAs) which can be canceled at any time, unlike most annuity contracts. Keep in mind that CDAs are sold by only a few companies and may be illegal in some states in the U.S., including New York.
Payout Options for Deferred Annuities
Once an annuitant reaches the distribution phase of their contract, which typically begins when they reach the age of 59 ½, they can receive payouts from the annuity in one of three ways.
Deferred Annuity Payout Options
Death Benefits
If you die during the accumulation period, a deferred annuity includes a basic death benefit that pays some or all of the value of the annuity to your beneficiaries. If you die during the payout phase, your beneficiaries may not receive anything unless you have a specific provision in your annuity contract providing for your beneficiaries to be paid.
Types of Deferred Annuities
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Deferred annuities come in a few different varieties, each with different features and benefits. The most common types of deferred annuities are single premium deferred annuities and flexible premium deferred annuities.
Single premium deferred annuities are purchased with one lump sum of money.
There are advantages and disadvantages to single premium deferred annuities. For example, a single premium deferred annuity might tie up more of your money than you ultimately could afford to put into it, which could wind up costing you a surrender fee.
A flexible premium annuity is a type of deferred annuity purchased with a series of payments. These payments can be scheduled as specific amounts — known as scheduled premium deferred annuities — or they can be adjustable. When the payments are adjustable, the vehicle is commonly referred to as a flexible premium deferred annuity.
How Is a Deferred Annuity Different from Other Types of Annuities?
“A deferred annuity is an annuity that allows you to delay receiving payments until a later date,” said licensed insurance agent Linda Chavez. During the deferral period, also known as the accumulation phase, the annuity contract earns interest and increases in value.
An immediate annuity is structured differently and does not have an accumulation phase. Immediate annuities undergo annuitization as soon as the contract is signed, which means the income payments can begin immediately. That said, many immediate annuity owners elect to initiate the payment stream up to a year after purchase.
Accumulation and Payout Phases of a Deferred Annuity
As mentioned, there are two distinct phases to a deferred annuity: the accumulation phase and the payout phase.
During the accumulation phase, the annuity accumulates interest on a tax-deferred basis. During the payout phase, the annuity distributes income.
The accumulation phase works differently depending on the annuity type.
Accumulation Based on Type of Annuity
Regardless of the type of accumulation your deferred annuity uses, you don’t pay taxes on those earnings during the accumulation phase. Taxes are not due until you reach the payout phase. This is true for federal income taxes and any applicable state premium taxes.
Frequently Asked Questions About Deferred Annuities
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