Deferred annuities are a type of savings option where you can grow money on tax-advantaged basis and can also convert (or “annuitize”) the annuity when you are ready to start receiving an income stream.
Also often referred to as a deferred income annuity, these financial vehicles can provide you with a higher future income stream than some of the other “traditional” income options like bonds or CDs.
Deferred annuities differ from immediate annuities in that an immediate annuity will begin paying income within 12 months of purchasing it, whereas income from a deferred annuity may not begin until some time in the future. In fact, in the case of a deferred income annuity (DIA), you could defer the income for up to 30, or even 40 years.
A deferred annuity can either be fixed or variable. You may also opt to purchase an indexed deferred annuity. So, depending on the type of annuity you choose, deferred annuities could allow you to avoid the constant ups and downs of the market, while at the same time keeping your principal safe.
There are two distinct phases of a deferred annuity. These include the “accumulation” phase and the payout – or annuitization – phase. With a deferred income annuity, you can choose to make just one single lump sum contribution, or alternatively, to make multiple payments over a long period of time.
During the accumulation phase, the funds that are inside of the deferred annuity are allowed to grow tax-deferred. This means that there is no tax due on the annuity’s gains until the time they are either withdrawn or paid out as an income stream.
This tax-deferral can really help to grow your account value because your funds are generating a return on the principal, as well as on the interest, and on the money that otherwise would have been paid out in gains taxes each year. Upon withdrawal, gains will be taxed at your ordinary income tax rate.
You may be able to access at least some of your money penalty-free during a deferred annuity’s accumulation phase. (With many annuities, up to 10% of the contract’s value may be withdrawn without penalty each year). If you take out more than that amount – and the annuity is still in its surrender period – you will be penalized by way of a surrender charge.
Deferred income annuity surrender charges usually last for several years after you purchase the product. (Although in some cases, the surrender charge period can last for a dozen or more years). The amount of the surrender charge will generally start out at a high percentage rate, and then gradually grade down over time until the penalty reaches 0% and disappears.
If you opt to withdraw money from a deferred annuity before you have reached age 59 ½, you can also incur an additional 10% “early withdrawal penalty” from the IRS. So, it can be quite costly to take out most – or all – of the money you have in a deferred income annuity within the first several years of owning it.
It is important to note that, with some annuities today, you are allowed to access your funds penalty-free in certain situations such as being diagnosed with a terminal illness or having to reside in a nursing home facility for a certain period of time.
The second phase of a deferred annuity is the income payout period. When you are ready to convert, or annuitize, the contract, you can begin receiving a regular stream of income. This income may last for a certain period of time, such as 10 or 20 years, or it could continue for the remainder of your lifetime – regardless of how long that is.
The income stream from a deferred annuity may also be able to continue for more than just one person. For instance, with the joint and survivor annuity income option, you and another individual – such as a spouse or partner – can both receive incoming cash flow for the rest of your lives.
Because of the reliable income that an annuity can provide, it helps to reduce the worry about running out of money in retirement. This, in turn, can allow you to enjoy your retirement years, knowing that income will continue to come in for as long as you need it. It also means that you can continue to keep a portion of your remaining assets in other, growth-oriented, investments that can help with meeting or beating future inflation.
Deferred annuities can also help you to enhance your long-term savings. Because the growth that takes place in the account is tax-deferred, you can continue to build your portfolio on a tax-advantaged basis, even if you have “maxed out” your annual contributions with a traditional IRA and/or 401(k) plan. Without having to pay tax on your annual gain in an annuity, funds can grow and compound exponentially.
Because a deferred annuity can be either fixed or variable, you can better “customize” a plan that works best for you and your specific objectives. For instance, with a fixed deferred income annuity, you will not incur loss to your principal, no matter what happens in the stock market.
Rather, your gains in the fixed annuity can continue to build upon previous growth, without the need to make up for any past losses. So, fixed deferred annuities can be a good option for those who are risk averse. The interest rate on a fixed deferred annuity is set by the insurance company, and it can usually be revised over time.
With a variable deferred annuity, your return is tracked based on the performance of underlying equity investments (such as mutual funds). Therefore, variable deferred annuity rates can be higher than those of a fixed deferred annuity. But there is also a “tradeoff” because variable annuities can come with market-related risk.
An indexed deferred annuity allows you to earn a return that is based on the performance of an underlying market index, such as the S&P 500 – up to a certain maximum, or cap. These annuities can also help to protect you from market downturns by simply crediting your account with a 0%, as versus with a loss.
While your money is allowed to grow without taxation inside of an annuity, you will typically be required to pay tax when you withdraw money and/or start taking your income payments. The portion of your income or withdrawal that is taxed is based on whether the annuity is qualified or non-qualified.
For instance, with a qualified annuity, your contributions are not typically subject to income tax before they are deposited. Plus, your account grows tax-deferred. So, since none of these funds have yet been taxed, 100% of your withdrawal or income payment will be considered taxable income. Many retirees “roll over” their traditional IRA and/or employer-sponsored retirement savings into a qualified annuity in order to generate income in retirement.
On the other hand, a non-qualified annuity is one where your contributions have already been taxed before you deposit them in the account. In this case, then, only the portion of your withdrawal or income payment that is considered gain will be subject to tax.
Because they are a type of tax-deferred income annuity, deferred annuities allow gains in the account to compound over time. The exact amount of your taxable versus non-taxable annuity withdrawals in a non-qualified annuity is determined using a concept called the exclusion ratio.
If you recall working with time value of money scenarios in high school algebra class, here’s where you can fit this concept into real life situations. The time value of money refers to what a dollar in your pocket is worth today as versus what it will be worth in the future.
For instance, a deferred annuity essentially represents a series of income payments that are received at regular intervals in the future. In this case, the present value of the annuity is the amount of money that you would need today that, if invested at the annuity’s interest rate, would equal the sum of all of the cash flows you would receive from it over its lifetime. This concept is often times referred to as the deferred annuity formula.
An example of the deferred annuity formula would be to take the present value of $100,000 and discount it in order to find the present value as of today. There are several websites on the Internet that can help you with the deferred annuity formula. But even these can be somewhat confusing.
Because of that, it is recommended that you talk with an annuity specialist who can guide you through all of the steps in the process. That way you can obtain a much better understanding of how the formula works, and what you can expect if you opt to purchase a particular deferred income annuity.
As it relates to annuities, the term “defer” refers to the fact that you do not have to convert the annuity to an income stream until a time in the future, if ever. By doing so, your account value can grow – in some cases, significantly – over time, particularly because there are no taxes due on the gain until the time of withdrawal.
Contrast this with an immediate annuity where you typically contribute one lump sum (either from personal savings or a retirement account), and income begins right away (within 12 months of purchasing the annuity).
So, if you are considering the purchase of an annuity, one of the key questions you should ask yourself is whether you want income to begin now (with an immediate annuity), or income to begin later (with a deferred annuity). Having a clear idea of your savings, investment, and retirement income goals can be extremely beneficial when deciding whether to buy an immediate or a deferred income annuity.
Even though a deferred annuity can provide a long list of growth and income benefits, the truth is that these financial vehicles are not right for everyone. So, before you move forward and commit to a long-term annuity, it is recommended that you first talk with an annuity specialist who can help you to narrow down which – if any – annuity is best for you.
At Sooner Retirement, our focus is on helping consumers learn how annuities work, and then determining whether or not an annuity is right, based on specific long and short-term financial goals, time frame, and risk tolerance.
Because annuities can come with a lot of “fine print,” talking with an annuity specialist can also help you to better understand what you can anticipate if you purchase a particular annuity. So, feel free to reach out to us here at Sooner Retirement – even if you just have general annuity questions.
We can be contacted via email through our secure online contact form secure online contact form here to set up a convenient time to chat. Or, please call us directly, toll-free, at (918) 938-7734 if you’d like to talk with an annuity expert today. We look forward to hearing from you.