Ensuring your retirement income is sufficient and will offer you peace of mind in those final decades of your life is important.
While individual retirement accounts (IRAs) and 401(k) serve as the most popular and reliable strategies to secure retirement income, these are not your only options. Many people explore various investment opportunities, such as annuities, in order to diversify their financial retirement plans, and there are many benefits to that approach.
What are deferred annuities? How do they work, and what kind of risks do they bear? We answer all of these questions below.
Key Takeaways
- With deferred annuities, you have the opportunity to contribute premiums upfront and receive the payout at a later date, which could be months, years, or even decades in the future.
- Different types of deferred annuities exist, including fixed, variable and fixed-indexed.
- By choosing annuities, you can benefit from tax-deferred growth, which means that you are not obligated to pay income taxes until the funds are withdrawn.
- A deferred annuity can be acquired through a single lump sum payment or a series of payments spread over a designated duration.
What Is A Deferred Annuity?
An annuity is an investment product that entails you making a lump sum payment or series of payments in exchange for receiving money later in a lump sum or regular installments, which most people use as retirement income.
A deferred annuity is a type of annuity contract that allows you to structure your retirement income in a specific way. In this case, a saver who enters a deferred annuity contract agrees to have their annuity payments deferred or simply delayed in time.
That is the most substantial difference between deferred annuities and immediate annuities, which offer annuity payments instantly after signing the contract. There is also an option to purchase a split-funded annuity, which combines the benefits of immediate and deferred annuities.
How Do Deferred Annuities Work?
In order to truly understand what deferred annuities are and how they can benefit you, it’s helpful to learn about how they work in practice.
A deferred annuity has two phases:
- The accumulation period – This is the time in which you either pay a lump sum or your payment installments to the insurance company you signed a contract with. Paying into your annuity makes your balance account grow tax-free.
- The payout period – Second phase is when you start receiving the annuity payments. The payment amount will depend on factors such as the initial investment amount, the contract’s duration, and the growth rate.
A saver can decide on receiving deferred annuity payments for a set period of time (for example, 15 years) or for the rest of their life. Of course, this means that the longer your annuity term is, the smaller the annuity installments you can expect. After a consultation with your insurance company, you should have a better idea of how much money per monthly payment you will receive based on different parameters and terms set in your annuity contract.
Types of Deferred Annuities
In most circumstances, there are three main types of deferred annuities that you can consider.
Fixed Deferred Annuity
Fixed deferred annuities come with a guaranteed minimum rate of return. What this means is that the insurance company offers you a certain return on investment, lowering the risks you face when purchasing an annuity. Usually, you can expect lower annuity payments with fixed annuities, but it’s a solid option for those who are risk-averse.
Variable Deferred Annuity
A variable annuity is essentially dependent on the performance of investments made by the insurer. When choosing this annuity, your money is being invested in various investment products, like stocks, bonds, or money market accounts.
One considerable advantage of variable annuities is the fact that they offer the potential for a higher rate of return. However, on the flip side, if the investments underperform, you may receive a very small return or even a negative one.
Variable deferred annuities offer a chance to build considerable income payments, but they also come with a fair share of risks, something worth careful consideration when making a decision about this purchase.
Fixed Indexed Deferred Annuity
The third type, which is fixed indexed deferred annuity, acts as a midway between fixed and variable annuities. This type presents you with a return that is directly tied to a specific market index, such as the S&P 500.
Indexed annuities offer both a minimum rate and a maximum rate of return, so you can benefit from a safety net that fixed annuities bring to the table while still opening the door for some nice returns. For this reason, fixed-indexed annuity contracts are one of the most popular among those who want to minimize their risks and maximize their profits.
Annuity Types by Term
We already talked about term deferred annuities, which are bound by a set period, and lifetime deferred annuities, which offer annuity income for the rest of the saver’s life. But let’s take a closer look at these and two other annuity types.
Term Deferred Annuities
This annuity will be valid for a set period. If you die during its term, the money will be going to people you named your inheritors. After the terms end, you won’t qualify for more payments, even if you’re alive.
Lifetime Deferred Annuities
As the name itself suggests this type of annuity offers a guaranteed income for the rest of your life. However, unlike a term deferred annuity, a lifetime annuity does not guarantee payments surpassing your death. Even in cases when you haven’t been able to recoup your investment, your family won’t be able to receive the rest of the money from your annuity.
There is an option to get around it by purchasing a dual-life annuity, which basically guarantees your spouse or a person of your choosing the income payments from the annuity after your passing. Another variant of this annuity comes with a death benefit that entitles your heirs to a portion of your annuity’s value following your death.
Annuity Types by Purchasing Method
Single-Premium Deferred Annuities
You can buy a single premium deferred annuity by paying a single lump sum payment for your contract. Often people use funds from their savings accounts, like 401(k), to make such a purchase.
Flexible-Premium Deferred Annuities
With a flexible premium deferred annuity, you can pay for your contract in smaller, regular installments. This is a valuable option for those who, for example, do not want to use the funds from their retirement plans to finance the annuity.
By making small payments towards your deferred annuity, you are able to build over time a considerable account value, increasing the potential return rates.
The Pros And Cons Of Deferred Annuity Contracts
As you may know, after this introduction, deferred annuities present some great opportunities for investors, especially for retirees who want to build a stable and diversified retirement financial plan. Still, there are no perfect solutions, so before you make any decisions, it’s worth taking into account all the drawbacks of deferred annuity contracts.
Let’s start with the positives first.
Pros
- Tax-deferred growth. As with all annuities, a deferred annuity allows you to save a considerable amount on a tax-deferred basis. This means you won’t have to pay taxes from profits you make while investing until the moment the funds get withdrawn. Additionally, if you finance your annuity with after-tax money, you will be exempted from additional income tax liability.
- Unlimited input. Another crucial benefit of deferred annuities is the fact there is no limit to how much money you can use to put into your account. Such a solution presents value for high earners who want to benefit from tax-deferred investments but who maxed out their 401(k).
- Higher growth with time. Similar to how a stock market works, the longer you invest your money, the bigger returns you may expect. The benefit of time is not one to be ignored. Most annuities, including deferred annuities, are viewed and utilized as long-term investments, allowing your contribution to grow substantially across years and decades.
- Various benefits. In addition to all the previous benefits, some annuities come with built-in benefits, such as death benefits, survivor’s benefits, or guaranteed minimum lifetime payout, among others.
Cons
- High fees and early withdrawal penalties. When buying an annuity, you can expect all sorts of fees to come your way. Apart from sales commission and other fees, you may be charged with early withdrawal penalties and taxes if you withdraw the money before the age of 59 1/2. It’s crucial to educate yourself on what type of costs you can expect before you sign the contract.
- Complexity. Many investment products introduce a level of complexity that may be hard to face without the proper preparations. Annuity contracts are complex and include lots of invaluable information regarding fees, guarantees, and other terms, so if you want to make sure you understand them correctly, it’s recommended to consult a financial advisor.
- Poor liquidity. Contract cancellation is rather difficult when it comes to annuities. When you want to access your money earlier, you will have to face penalties and additional fees.
The Deferred Annuity Formula
Just like we mentioned before, the best way to learn all about terms, potential benefits, and earnings from your annuity, it’s best to talk to a financial adviser. But if you want to calculate your deferred annuity returns, you can do so by following a rather simple formula.
FV = P * (1 + r/n)^(nt)
- FV – future value
- P – principal amount
- r – the annual interest rate
- n – the number of times the interest gets compounded each year
- t – time
Deferred Annuity Payout Options
In most cases, you’ll be able to withdraw the money from an annuity in three different ways.
Lump sum
You can receive the money from your deferred annuity as a single, taxable lump sum payment.
Systematic withdrawals
Many choose to receive the money via systematic withdrawals, which provides the benefit in the form of continuous interest rate growth until the account gets depleted.
Annuitization
Annuitization is similar to systematic withdrawals, as it assumes regular monthly, quarterly, or yearly payments, done in a set period or until the moment you or your spouse dies.
Who Needs a Deferred Annuity?
Who should consider purchasing a deferred annuity? If you’re:
- getting close to retirement age;
- want to diversify your financial retirement plan;
- looking for a safe and profitable way to invest your money and secure your future;
- have accumulated enough savings or earn enough money to support the additional cost of deferred annuity;
This investment product might be for you. You may want to consult your financial advisor or annuity experts in order to determine whether this is something you should consider and what type of annuity best suits your needs.
Bottom Line
Hopefully, at the end of this guide, you have a much better idea of what deferred annuity is and what advantages and drawbacks it can offer you. Although the topic of annuities and financial retirement plans can be complex or even daunting, it’s in your best interest to learn about it, so you can make the best choices for yourself and ensure you’re well-equipped to enjoy the last years of your life.
At Annuity Association, we work hard to provide our clients with expert advice on the best annuity products on the market. See our annuities reviews and get the most accurate information from the reliable source.
Contact us today if you have any questions at all. We’re here to help you plan your retirement financial safety net with ease.
Deferred Annuities Frequently Asked Questions
How soon do payments begin with a deferred annuity?
Most savers will start to receive annuity payments after reaching retirement age. It’s difficult and, in most cases, quite expensive to withdraw money before that time.
How are deferred annuities taxed?
Annuities grow tax-deferred, which means you’re exempted from paying income taxes until the moment money gets withdrawn. When withdrawn, you will need to pay income tax if you purchased the annuity with pre-tax funds, or pay tax on the earnings, if you used post-tax funds to finance the annuity.
Deferred annuities tax benefits allow people to invest their money on much more favorable terms, but it’s crucial to know this is not a completely tax-free investment.
Can you lose money in a deferred annuity?
Yes, it’s possible to lose money in a deferred annuity. This pertains to some types of deferred annuities, for example, variable annuities, that are tied to fluctuations in the market.
