What is Deferred Annuity?

Annuities are long-term investments that mean you get reliable and guaranteed income throughout retirement. You can buy an annuity with a lump sum or with an initial payment plus monthly, quarterly or annual premiums. Insurance companies sell different types of annuities to meet different needs. One type is deferred annuity.

About Deferred Annuity?

Deferred annuities are specifically designed for long-term savings. It’s an insurance contract that doesn’t start paying you right away. Investors can delay payouts indefinitely, though, during this period, earnings on them are tax-deferred. You can increase the value of the annuity by adding funds to the account. The best part of this investment option is that you can withdraw a lump sum from it whenever required.

Apart from that, it is possible to transfer to any other financial institution or withdraw the annuity. It allows you to easily convert an annuity into a payment stream at a specific date in the future. Over time, you earn interest on the assets present in the annuity. However, you need to pay a fee or tax for each option.

The charges you pay to the annuity company are in the form of income tax, surrender charge, withdrawal charge, and penalty tax. An essential aspect of deferred annuities is their annual fee. Around 1% per year is charged as asset, rider, and sub-account management fees. Therefore, before taking any decision regarding this investment, you must review all the details with qualified tax professionals. It will help you to make a sound and informed investment decision.

How Does a Deferred Annuity Work?

To understand what a deferred annuity is, you must first have a good understanding of how annuities work.

An annuity is a contract, usually with an insurance company, that offers income over a period of time in exchange for money. The annuity will be paid, usually monthly, according to the terms of the contract, often until the customer’s death, and may pay survivor benefits. These benefits may include an income stream for certain beneficiaries who survive the client.

The most attractive aspect of an annuity may be its safety. In many cases, the insurance company may offer a certain return on the money in the account or guarantee you a minimum payment value. It may also offer death benefits on an annuity, which is usually a life insurance-like payment upon the account holder’s passing.

What converts an annuity into a deferred annuity is when the client – ​​the annuitant, in industry parlance – receives the money. There are two primary methods to obtain your payments.

With a deferred annuity, clients can make contributions throughout their working lives, adding some money from work paychecks to their annuity. Of course, they can also give a lump sum. But the key point is that they agree to receive their benefits later, usually years later.

In contrast, with an immediate payment annuity, the client deposits a lump sum and begins receiving payments from the income almost immediately.

Annuities can also differ in terms of how they are structured. There are three major kinds of annuities – a fixed annuity, a variable annuity, and an indexed annuity. The risks and rewards of these can vary significantly, and it is important that consumers understand what they are buying before they buy.

These kinds of classes are not exclusive. Regardless of the annuity structure you choose—fixed, variable, or indexed—you’ll need to choose when it pays. That means you can have a deferred fixed annuity or a deferred variable annuity, for instance, or even an immediate fixed annuity.

Types of Deferred Annuities

As discussed, there are mainly four kinds of Deferred Annuities:

1. Fixed Deferred Annuity

A fixed deferred annuity is just the same as a cash deposit. This will provide you with a fixed rate of return on the amount present in your account. The minimum amount you get is fixed in advance. Although the payment may be more than the stipulated amount, it cannot be less than the minimum agreed amount. However, the interest will be deferred until you withdraw from the contract. This annuity is not the best option if you don’t want to earn interest.

2. Variable Deferred Annuity

In a variable deferred annuity, funds are held in an investment account and then invested, according to risk tolerance, age, and other factors. In this case, you have a limited choice, and that includes stocks as well as bonds. Here you cannot expect a fixed return as the returns vary according to the assets present in the chosen portfolio of the mutual fund. This will remain tax-deferred until you withdraw it. However, you can expect it to have rider options like future income or death benefits.

3. Indexed Deferred Annuity

These annuities are also called equity-indexed annuities. It is a combination of both fixed and variable deferred annuities. Some investors consider it as a fixed annuity because it guarantees you a minimum guaranteed return just like a fixed annuity. Along with that, you have the option of linking your earnings to a specific market index with a return-based formula. If you withdraw funds in the initial years of the contract, you will have to pay a surrender charge for it, and the penalty depends on the insurance company.

4. Longevity Annuity

This type of deferred annuity is considered the best among other types of annuity. It works like whole life insurance that pays you an amount throughout your life. You can smoothly spend your retirement savings and ensure your future. Till the age of 85, the tax on life annuity is deferred. Assuming the holder dies, the policy automatically passes to the authorized beneficiary.

How long are deferred annuities paid?

How your annuity pays out can also vary depending on how it’s structured. You can prefer different kinds depending on when exactly you require your money.

Lifetime Deferred Annuities

With a lifetime deferred annuity, you can choose to receive future payments that will last for the rest of your life. No matter how long you live, you will continue to receive payments until you die. However, once you die, the payments stop, even if you don’t live long after the payments start.

Fixed-Period (or term) Deferred Annuities

A fixed-period annuity, also known as a term deferred annuity, is a type of annuity that is paid over a specified period of time. For example, it can be paid over 10 or 20 years. If you die unexpectedly during the payment term, you can continue paying the beneficiary. At the end of the term, the payments will stop, even if you are still alive.

Pros of a Deferred Annuity

Like any investment, deferred annuities have many benefits.

Tax-Deferred Investment

Owners don’t pay taxes during the accumulation stage. Taxes apply once the distribution phase begins and the owner begins receiving payments.

Guarantees Against Loss

Most deferred annuity contracts have built-in guarantees against the loss of principal or offer guaranteed rates of return.

Lifetime Benefits

If you annuitize your contract, insurance companies guarantee lifetime payouts until your death or your spouse’s.

Death Benefits

A deferred annuity contract includes a death benefit component. This ensures that any surviving heirs will receive any remaining assets if you die before the end of the annuity contract.

No Contribution Limits

Unlike IRAs and 401ks, the IRS places no limit on the principal amount you can contribute to a deferred annuity.

Cons of a Deferred Annuity

Like any investment, deferred annuities carry many risks.

Lack of Liquidity

Annuitants are incapable to withdraw any funds from their annuity during the first few years of the contract unless they bear a surrender charge for withdrawals. Additionally, you will pay a penalty to the IRS for any withdrawals made before you are at least 59 and a half years old.

High Tax Rates on Earnings

As annuity contracts rise on a tax-deferred basis, the IRS taxes annuity earnings at regular income rates, which may be higher than the capital gains rates appropriate to stocks, mutual funds, and exchange-traded funds.

Additional Expenses

Deferred annuity contracts can be expensive to maintain due to administrative fees, fund costs, charges for special features and riders, and commissions.

Who should go for a deferred annuity?

Annuities can meet the needs of many people, because of the guaranteed income stream when they are no longer able to work. But they also have some significant drawbacks.

Someone who is nearing retirement and will require income in the near future might think about a deferred annuity for a part of their assets.

Combine the deferral feature with a fixed contract — which promises a minimum return on your investment — and this annuity offers a lot of security for a retiree, especially when combined with Social Security.

Those who want the potential investment returns of stocks without some risk can consider variable deferred annuities. In a variable annuity, the investor deposits money in stock mutual funds, among others, and can have a minimum guaranteed income.

Should you include a ‘rider’ in your deferred annuity?

While annuities come with many great benefits, they may not have everything you’re looking for. Companies may offer different riders to customize your annuity to suit your needs. Fees are involved for adding riders, so you should always discuss these options with a financial professional before purchasing your contract.

Some of the popular riders available today include:

  • Death benefit rider: Provides you the capability to set death benefits for your heirs.

  • Lifetime Income Benefit Rider: Guarantees that you will receive regular income payments for the rest of your life, even if your annuity is fully exhausted.

  • Cost of living (COLA) rider: It provides an increase in your monthly payments, based on inflation.

Can you Lose your Funds with a Deferred Annuity?

When it comes to retirement planning, annuities are a famous choice. They can offer a steady stream of retirement income that can last a lifetime and help protect your nest egg from market volatility.

However, not all deferred annuities are designed similarly.

  • Fixed indexed and fixed deferred annuities don’t lose funds, even if the markets move downside.

  • However, with a deferred variable annuity, your account value can increase or decrease according to the performance of underlying investments. As a result, you could potentially lose money with a variable annuity if the markets take a turn for the worse.

If you’re considering annuities as part of your retirement planning, be sure to contact us about the different types of annuities to learn about income and investment guarantees and which one is right for you.

Tax Treatment of a Deferred Annuity

If your investment rises during the accumulation stage, the gains are tax-deferred. This means you don’t owe federal income tax on the payments until you receive them. Tax-deferred benefits allow your earnings to grow more efficiently. Thanks to compound interest — and more money working for you because of pre-tax contributions — your balance can grow at a faster rate than if you contributed after-tax money. Once the payments begin, they will be taxed as ordinary income.

Your heirs will have to pay federal income tax on the annuity payments or the lump sum they receive after your death. (This differs from regular life insurance benefits, which are generally not taxable.) However, taxes on annuity benefits can be complicated, so be sure to consult a tax professional.

Difference Between Tax Deferral and Deferred Annuity

Often investors get confused between tax deferral and deferred annuity. Tax deferral is one of the features of the annuity. Generally, you don’t pay tax on the income you receive in an annuity. You pay tax when the money comes out of the tax-deferred account. When you keep the amount in the contract and continue to reinvest the earnings and earn interest on those earnings again, you earn more with the benefit of compounding.

Deferred Annuity vs. Immediate Annuity

The difference between a deferred annuity and an immediate annuity is fairly self-evident. An immediate annuity starts paying benefits immediately. Deferred annuities stay quietly for years before you go for any withdrawals.

Many deferred annuity contracts will have a process to convert them into an immediate annuity, should you need your money sooner than you expect. However, it may take several years before this option becomes available. It may also come with an unpleasant fee. If you buy a deferred annuity, you should plan on not seeing your money back for several years.

Conclusion

By reading the above article you can now make an informed choice about whether you should invest in a deferred annuity as a long-term investment or not. Investing in deferred annuity has both advantages and disadvantages. Whether or not it’s worth a long-term investment depends entirely on your retirement priorities, risk tolerance, and financial goals. Generally, a deferred annuity is considered a safe investment option as it is only sold contractually by insurance companies, and strict laws regulate it properly.

Additionally, unlike other retirement investment accounts, there is no upper limit on contributions. Also, charges and fees are the biggest drawbacks in annuities compared to other retirement investment options. The final decision depends entirely on your goals and an informed decision needs to be made to secure your future.

Frequently Asked Questions about Deferred Annuities

1. How soon can benefit payments begin with a deferred annuity?

Answer: Generally, payments can start after two years from the date of policy issue.

2. What is a tax-deferred annuity plan?

Answer: A tax-deferred annuity (TDA) plan is a retirement savings vehicle that invests pretax dollars in a deferred annuity (tax-free until the annuity owner begins receiving payments). It is designed to supplement your employer’s base retirement plan. Sometimes, a TDA plan is also referred to as a voluntary savings plan, supplemental plan, tax-sheltered annuity (TSA), or simply a 403(b) plan. Contributions to tax-qualified retirement plans already enjoy tax deferral; Therefore, buying into a tax-deferred annuity, or fixed-income annuity, does not provide any additional tax deferral benefits.

3. Can I withdraw my funds early?

Answer: Early withdrawal or withdrawal of funds before the individual reaches 59.5 years may attract a penalty. Investors will have to pay a 10% penalty tax on the withdrawn funds as well as the tax due on the withdrawn funds.

4. Are pension and deferred annuities similar?

Answer: No, although both are retirement savings plans, they are different. In a pension, a person saves funds from their income and receives it after retirement. In a deferred annuity, income is received from the invested funds by the investor. However, investors don’t have to wait until retirement to reap the benefits.