Consumers use a variety of financial products to fund their retirement dreams, and deferred annuities are just one option out there. If you are angling for benefits like tax-deferred earnings and guaranteed income in retirement, read on to learn how deferred annuities work and who they work best for.
What Is a Deferred Annuity?
A deferred annuity is a contract with an insurance company where they promise to generate income for retirement in exchange for an upfront investment.
Generally speaking, the individual who purchases the annuity makes payments or puts down a lump sum of cash, which is invested on their behalf. At some point in the future, the insurance company pays the owner of the annuity guaranteed income or a lump sum they can use for retirement.
How Deferred Annuities Work
A deferred annuity works like other types of annuities. You transfer cash to an insurance company who invests your money on your behalf based on a strategy you pick ahead of time. Some people choose to invest in an annuity with a lump sum of cash, whereas others make regular payments toward their annuity based on the terms in their contract.
There are three types of deferred annuities to choose from, and each one has specific advantages and disadvantages.
- Fixed annuities promise a guaranteed rate of return on the money invested, which makes it possible to plan for retirement without market risk. This type of annuity is "safer" for investors since their return is guaranteed, yet their rate of return will be less as a result.
- Indexed annuities base your return on the performance of a market index, such as the S&P 500. This type of annuity offers returns that are riskier than fixed annuities yet easier to anticipate than a variable annuity.
- Variable annuities base your returns on the performance of investments that are chosen by you and the insurance company. This type of annuity involves quite a bit more risk, and it tends to be more complicated and harder to understand.
When you purchase any type of annuity, tax-free growth is one of the major benefits you can look forward to. In fact, individuals who buy annuities only pay taxes when they begin receiving income in the future, whether in the form of regular payments or a lump sum.
There are two main phases involved in the purchase and usage of an annuity — the accumulation phase and the payout phase. True to its name, the accumulation phase takes place when the purchaser of the annuity is paying into the product. Likewise, the payout phase takes place when the owner of the annuity begins receiving income.
Deferred Annuity Example
The easiest type of deferred annuity to understand is the fixed annuity, and for obvious reasons. If you're considering a deferred annuity that offers returns you can count on, you can easily find this type of annuity with major companies in the insurance space, including USAA.
With the USAA Fixed Guaranteed Growth (FGG) Annuity, individuals can invest a lump sum of money that earns a guaranteed interest rate for a specific period of time. After that initial growth period, the annuity can continue to earn interest at a rate that is not guaranteed. The money is able to grow on a daily basis, and consumers don't pay taxes on earnings until they begin receiving payments.
That all sounds wonderful I'm sure, but the downside of fixed annuities comes in the form of a relatively low rate of return. With the 10-year USAA Fixed Guaranteed Growth (FGG) Annuity, for example, the current rate is set at 1.75% to 2.15% depending on the amount deposited.
That is barely enough to keep up with inflation, let alone generate additional income for retirement.
Taxes And Withdrawals
There are other important details to understand about deferred annuities, including their tax treatment and penalties for early withdrawals. When it comes to taxes, it's worth noting that annuity funds are able to grow on a tax-deferred basis. This means you won't pay income taxes on an annuity until later on when you begin receiving payments.
Once you take a lump sum of cash or begin receiving income from an annuity, how that income is taxed depends on one other factor — whether your annuity is qualified or non-qualified.
- Qualified annuities are funded with money that you have not paid income taxes on yet, such as funds invested within a 401(k) or other tax-deferred retirement account. Thus, payments from qualified annuities are taxed at your ordinary income tax rate.
- Non-qualified annuities are funded with money you have already paid income taxes on. As a result, you'll only pay taxes on earnings in the annuity, and not your initial deposits.
While tax-deferred growth is a major advantage of annuities, it's important to have a long-term plan when you invest in this type of retirement vehicle. If you need to take a lump sum from an annuity or you try to cancel the contract before the age of 59 ½, the Internal Revenue Service (IRS) is able to charge a 10% early withdrawal penalty on top of the income taxes you'll owe.
Separately, insurance companies that sell annuities also include surrender charges in their contracts. These surrender charges come into effect if you need cash from your annuity early, or if you need to cancel the contract early, usually within up to seven years after the purchase. While annuity surrender charges can vary, these are typically charged as a percentage of the annuity, often as high as 10% or more.
With all this in mind, it's easy to see why annuities are best used for long-term investing instead of short-term gains. By and large, annuities should only be used if you are unlikely to need your money until your annuity contract ends.
Deferred Annuity vs. Immediate Annuity
While deferred annuities defer your payments until an agreed-upon date in the future, immediate annuities do the exact opposite of that. With an immediate annuity, you pay in a lump sum of cash in order to begin receiving payments right away.
Because immediate annuities don't provide a similar runway of time for your money to grow, the trade-off with this type of annuity often comes in the form of lower returns.
Deferred Annuities: Pros and Cons
The pros and cons of this type of investment can vary depending on the type of deferred annuity you buy. After all, fixed annuities work much differently than variable annuities since their returns are generated based on entirely different methods.
However, we summarize the main advantages and disadvantages of deferred annuities below.
Benefits of Deferred Annuities
- You can choose your investment style. You can select the type of annuity and returns you want, whether you choose a fixed annuity, an annuity with returns based on an index, or a variable annuity with investments you choose on your own.
- Generate income for retirement. Deferred annuities help generate income you can use to fund your golden years.
- No maximum contribution. Unlike other tax-deferred retirement plans, including 401(k) plans, deferred annuities do not come with an annual limit for contributions.
- Tailor your policy with riders. Some insurance companies let you personalize your annuity with additional riders. As an example, you could purchase a rider that guarantees a death benefit for your heirs if you die before you can take payments from your annuity.
Potential Downsides of Deferred Annuities
- Pay taxes on early withdrawals. If you need cash from your deferred annuity before age 59 ½, the IRS can charge a 10% early withdrawal penalty on top of the income taxes you owe.
- Poor liquidity. Unlike other types of investments that can be sold when you need them, annuities are not easily liquidated without paying surrender charges.
- Fees can be costly. Fees are often hidden within a deferred annuity's structure, and they may be higher than you'll find with other investments.
- Deferred annuities can be complicated. Annuity contracts can be difficult for even savvy investors to understand.
Is a Deferred Annuity Right for You?
If you want to generate income in retirement and you are willing to do some legwork, a deferred annuity could be what you need. Just keep in mind that you have to determine the type of deferred annuity that would suit your needs best, and that you should be wary of early withdrawal penalties and surrender charges that can apply if you need cash before your payments are scheduled to begin.
Also note that financial advisors often earn huge commissions on annuities, and that advisors who earn commissions may have their own best interests in mind. If you are shopping for an annuity, it can help to speak with a fiduciary who is legally required to put your financial interests first.