What Is a Deferred Annuity?


June 18, 2021

What Is a Deferred Annuity?

June 18, 2021

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Annuities can provide supplementary income to your primary retirement savings. If you are looking to add some security to your portfolio with a guaranteed retirement paycheck and have several years before your retirement, a deferred annuity might be right for you.

What Is a Deferred Annuity?

A deferred annuity is an insurance contract in which the insurer agrees to pay the annuitant a regular income at a later date, in contrast to immediate annuities, which begin paying immediately (or within one year of opening the policy). Deferred annuities can be fixed, indexed, or variable, which affect payments, rates of returns, and overall cost, among other things. Fixed annuities have a specific guaranteed payment, while payments from indexed and variable annuities are based on the performance of either a specific market index (for indexed annuities) or a mutual fund portfolio (for variable annuities). Your payment amount is based on a variety of factors, including your age, gender, expected lifespan, annuity type, additional riders, and more.

Because these types of annuities are deferred and grow over time, they have two phases: accumulation and payout. The accumulation phase (sometimes called the investment phase) is the deferral period before which the annuitant begins receiving payments when the annuity is collecting interest. The payout phase (sometimes called the income phase) is when the insurer begins making payments, as outlined in your contract. You can opt to receive your payments in one lump sum, for a set amount of time (called a term deferred annuity), or annuitize your payments over the course of the rest of your life (called a lifetime deferred annuity). You can also purchase various riders for an additional cost, like a death benefit that will continue paying your beneficiary until all funds have been withdrawn. You can also purchase your annuity jointly with your spouse, which guarantees payments through the surviving spouse’s lifespan.

Once you finish funding your annuity, you enter the surrender period, meaning you cannot withdraw more than 10% of your annuity funds without paying a significant fee. The surrender fees decrease by 1% each year until they reach zero—the end of your surrender period. Once you reach the end of the surrender period, you can withdraw funds without incurring a penalty. Surrender fees and IRS penalties are independent of each other, so you have to pay both for any early withdrawals that meet the surrender qualifications—in addition to the income taxes you’ll have to pay.

Types of Deferred Annuities

As mentioned above, deferred annuities can be fixed, indexed, or variable, and each type has advantages and disadvantages. A fixed annuity is the least risky as it has no market exposure, but it comes with lower returns, in general. Your annuity’s interest rate is determined when you purchase the annuity and doesn’t change. A variable annuity invests your premium in mutual funds called subaccounts based on your risk tolerance and other factors and mimics the performance of this variety of stocks, bonds, or money market funds. There is no guaranteed rate of return on this type of annuity; your interest rate—and thus payment—is based on their performance. Variable annuities can offer greater returns but come with the risk of poor fund performance. An indexed annuity is based on the performance of an index, like the S&P 500. These types of annuities generally have a cap on your returns (both at the bottom and the top), so you can’t lose your principal but also can’t realize a gain above a certain percentage if the index is performing well. There is less volatility in this type of annuity compared to a variable annuity.

How Is a Deferred Annuity Funded and Taxed?

Deferred annuities are tax-deferred, meaning you pay taxes at normal income tax rates when you begin making withdrawals and receiving payments. You can contribute to your deferred annuity with pre-tax dollars, like 401(k)s or IRAs, then pay taxes when you reach the payout phase of your annuity. The IRS imposes a 10% penalty if you withdraw from your annuity before age 59.5.In contrast to 401(k)s and IRAs, there is no upper limit on principal contributions to your annuity, so you can contribute as much as you want to your principal. You can purchase your annuity with one lump sum (called a single premium deferred annuity) or a series of payments (called a flexible premium deferred annuity).

Is a Deferred Annuity Right for You?

Deferred annuities are an illiquid, long-term product. They can sometimes be converted into an immediate annuity but often not for several years after purchasing the annuity and with very high fees to do so. If you anticipate the need to access those funds before the payout phase or think you might be at risk for getting cold feet after purchasing, this type of annuity may not be right for you. Depending on your retirement priorities and existing investments, an annuity can offer some peace of mind and security to your portfolio, knowing you’ll have access to lifetime guaranteed retirement income. If you are a pre-retiree with several years (or more) to go before retirement, a deferred annuity can offer greater growth potential than an immediate annuity and may be the best option for you.

Consult a financial professional to determine if an annuity is right for you; if it is, they can help you evaluate your needs and match them with the right annuity. Annuities can be tricky and come with many complex fees and tax implications. A financial professional can help wade through the muck and help you feel confident with your decision.


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