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Deferred Annuities

A deferred annuity is a contract with an insurance company that promises to pay the owner regular income or a lump sum at a future date. Investors often use deferred annuities to supplement other retirement income, such as Social Security. Deferred annuities differ from immediate annuities, which begin making payments right away.

 

How Deferred Annuities Work

There are three basic types of deferred annuities: fixed, indexed and variable.

  • As the name suggests, fixed annuities promise a specific, guaranteed rate of return on the money in the account.
  • Indexed annuities provide a return based on the performance of a particular market index, such as the S&P 500.
  • The return on variable annuities depends on the performance of a portfolio of mutual funds, or subaccounts, chosen by the annuity owner.

 

Tax Deferral

All three types of deferred annuities grow on a tax-deferred basis. Owners of these insurance contracts pay taxes only when they make withdrawals, take a lump sum, or begin receiving income from the account. At that point, the money they receive is taxed at their ordinary income tax rate.

 

The period during which the investor pays into the annuity is known as the accumulation phase, or savings phase. Once the investor chooses to begin receiving income, the payout phase, or income phase, begins. Many deferred annuities are structured to provide income for the rest of the owner's life and sometimes for the life of their spouse as well.

 

They Are Investments

Deferred annuities are considered long-term investments because they are less liquid than, for example, mutual funds purchased outside an annuity.

 

  • Most annuity contracts impose strict withdrawal limits, such as allowing only one withdrawal per year.
  • Withdrawals may also be subject to surrender charges imposed by the insurer.
  • If the account owner is younger than 59½, they will generally face a 10% tax penalty on the withdrawal amount in addition to the income tax they must pay on the withdrawal.

Before purchasing an annuity, buyers should make sure they have enough money in a liquid emergency fund.

 

Deferred annuities often include a death benefit component. If the owner dies while the annuity is still in its accumulation phase, their heirs may receive some or all of the account value. However, if the annuity has entered its payout phase, the insurer may simply keep the remaining money unless the contract includes a provision to continue paying benefits to the owner's heirs for a certain number of years.

 

 

References/Information Sources

 

  1. Internal Revenue Service. "Topic No. 558, Additional Tax on Early Distributions from Retirement Plans Other Than IRAs." Accessed February 18, 2021.