What Is A Deferred Annuity?
A deferred annuity is a financial contract with an insurance company that promises to pay the owner a regular income or a lump sum of money at some future date.
Investors often use deferred annuities to supplement their other retirement income, such as Social Security. Deferred annuities differ from immediate annuities, which begin making payments right away.
One of the main advantages of deferred annuities is their tax-deferred growth. You won't owe taxes on the gains within the annuity until you start withdrawing funds. However, when you do make withdrawals, the gains are taxed as ordinary income.
Types Of A Deferred Annuity
There are three main types of deferred annuities:
- Fixed annuities: Fixed annuities offer a guaranteed rate of return, so you know how much your money will grow over time. This can be a good option for investors who want to ensure that their money will grow safely.
- Variable annuities: Variable annuities don't offer a guaranteed rate of return, but your money can grow more quickly if the market performs well. This can be a good option for investors who are willing to take on more risk in exchange for the potential for higher earnings.
- Indexed annuities: Indexed annuities offer a combination of fixed and variable features. Your money grows with a guaranteed minimum rate of return, but it can also participate in the growth of a market index, such as the S&P 500. This can be a good option for investors who want to grow their money safely, but also want the potential for higher earnings.
In addition to these three main types, there are also a number of other variations of deferred annuities, such as:
- Lifetime deferred annuities: These annuities offer guaranteed income payments for life, regardless of how long you live.
- Fixed-period deferred annuities: These annuities offer guaranteed income payments for a set period of time, such as 20 years or 30 years.
- Joint and survivor deferred annuities: These annuities offer guaranteed income payments for the life of the annuitant and a designated beneficiary.
Example: How Does Deferred Annuity Work?
Let's walk through an example to illustrate how a deferred annuity works:
Sarah, a 50-year-old professional, wants to start saving for her retirement in a tax-efficient way. She decides to invest in a deferred fixed annuity.
Sarah purchases a deferred fixed annuity with an initial premium of $100,000 from an insurance company. The annuity has a guaranteed interest rate of 3% per year for the first 15 years.
During the accumulation phase, Sarah's $100,000 investment grows at the guaranteed interest rate. At the end of the first year, her annuity's value would be calculated as follows: Initial Investment + (Initial Investment * Guaranteed Interest Rate) = $100,000 + ($100,000 * 0.03) = $103,000
This calculation is repeated each year for the first 15 years. At the end of 15 years, Sarah's annuity value would have grown to: $100,000 * (1 + 0.03)^15 = $155,796.
At age 65, Sarah decides to start receiving regular income from her annuity. She has a few payout options to choose from:
- Life Annuity: Sarah can choose to receive a guaranteed income for life. Based on the annuity's value, her age, and the prevailing interest rates, the insurance company calculates a monthly income amount that she will receive for the rest of her life.
- Fixed Period Annuity: Alternatively, Sarah can choose a fixed period annuity, where she receives regular payments over a fixed period, say 20 years. The insurance company calculates the payment amount based on the annuity value and the chosen period.
- Joint and Survivor Annuity: If Sarah is married, she can opt for a joint and survivor annuity, which provides income for both her and her spouse's lifetime.
For the sake of illustration, let's assume Sarah chooses the life annuity option. The insurance company calculates that she will receive a monthly income of $600 based on her annuity value and life expectancy.
Sarah starts receiving her monthly income of $300 from the insurance company. T
his income is considered a mix of both her original investment and the interest earned over the accumulation phase. A portion of each payment is considered a return of her original premium, and the rest is considered interest income.
Throughout the accumulation phase, Sarah's annuity has grown on a tax-deferred basis. This means she hasn't paid taxes on the interest earned each year. However, when she starts receiving income payments, the interest portion of each payment is taxed as ordinary income.
Pros And Cons Of Deferred Annuity
Deferred annuities offer both advantages and disadvantages, and their suitability depends on your individual financial goals, risk tolerance, and circumstances.
Here are some pros and cons of deferred annuities:
Tax Deferred Growth:
Fees and Charges
Lack of Liquidity
Your money grows tax deferred in a deferred annuity, which means you don't owe taxes on any earnings until you start taking withdrawals. This can help your money grow faster over time.
Many deferred annuities offer guaranteed income payments for life, ensure a steady stream of funds throughout your retirement year and provide peace of mind in retirement.
You can choose when to start taking withdrawals from your deferred annuity, and you can also choose to receive your payments in a lump sum or as a stream of income.
Many deferred annuities (but not all of them) come with a death benefit. If the annuity owner passes away before the payout phase, a beneficiary can receive the contract's value, often with certain adjustments or limitations.
Deferred annuities can come with various fees and charges, including administrative fees, mortality and expense charges, and charges for optional riders. These fees can impact the overall return on your investment.
Annuities are designed for long-term savings and income. Withdrawing funds from an annuity before a certain period, known as the surrender period, may result in surrender charges.
This lack of liquidity can be a drawback if you need access to your money quickly.
Deferred annuities can be complex financial products, and it's important to understand all the terms and conditions before you buy one.
How Does An Deferred Annuity Differ From A Immediate Annuity?
The main difference between a deferred annuity and an immediate annuity is when you start receiving payments.
With a deferred annuity, you make payments into the annuity for a period of time, and then you start receiving payments at some future date. With an immediate annuity, you make a lump sum payment into the annuity, and then you start receiving payments immediately.
Both types of annuities have their own advantages and drawbacks. Deferred annuities can offer flexibility and growth potential, while immediate annuities provide a secure and predictable income stream. Your choice between the two will depend on your retirement goals, risk tolerance, and financial needs.
How To Select An Deferred Annuity?
Here are some tips to help you make an informed decision when selecting a deferred Annuity:
- Research Annuity Types: Learn about the different types of deferred annuities, including fixed, variable, and indexed annuities. Understand how each type works, their potential returns, and associated risks.
- Review the Contract: Read the annuity contract thoroughly, paying attention to terms, surrender charges, income options, and any limitations. If anything is unclear, ask for clarification from the insurance company or your financial advisor.
- Research Insurance Companies: Choose a reputable insurance company with a strong financial standing. Research their ratings and reviews to ensure they have a track record of fulfilling their commitments.
- Evaluate Your Risk Tolerance: Different types of deferred annuities carry varying levels of risk. Fixed annuities offer stable, guaranteed returns, while variable annuities expose you to market fluctuations. Assess your comfort level with risk and how much variability in returns you can tolerate.
- Consider Your Overall Financial Strategy: Annuities are just one component of a comprehensive financial plan. Consider how an annuity fits into your broader retirement and investment strategy.
- Review Costs and Fees: Deferred annuities often have fees, including administrative fees, mortality and expense charges, and fees for optional riders. These fees can impact your returns. Make sure you understand the costs associated with the annuity
Deferred Annuity vs 401(K)
Deferred annuities and 401(k) plans are both retirement savings vehicles, but they have distinct features, benefits, and considerations.
Here's a comparison between the two:
Tax Treatment: Both annuities and 401(k) plans offer tax advantages. Annuities offer tax-deferred growth, while traditional 401(k) contributions are made with pre-tax income.
Investment Options: 401(k) plans generally offer more diverse investment options, allowing you to build a customized portfolio. Annuities may have more limited investment choices.
Employer Contributions: Only 401(k) plans offer the potential for employer matching contributions, which can significantly boost your retirement savings.
Income Stream: Deferred annuities provide guaranteed income options during retirement, while 401(k) plans require you to manage withdrawals yourself, potentially leaving you exposed to market fluctuations.
Liquidity: 401(k) plans generally offer more liquidity than annuities, as you can access your funds after age 59½ with minimal penalties.
In summary, the decision between a deferred annuity and a 401(k) plan depends on your individual circumstances, goals, and preferences.
If your employer offers a 401(k) plan with a matching contribution, it's often wise to take advantage of that free money. Deferred annuities can be useful for those looking for guaranteed income options in retirement, but they also come with various fees and limitations.