Different types of annuities can help meet different goals. If you want income from an annuity right away, you might consider an immediate annuity. If you are planning ahead and want to receive income later, a deferred annuity may be a better fit.
Overview
With a deferred annuity, you can receive a lump sum or an income stream at retirement or at another time when you need the funds. These annuities are designed for long-term use and are often used for retirement or long-term growth.
For example, someone who is 50 years old might purchase a deferred annuity and plan to begin income at age 65 or even 80. The longer the time between when you buy the annuity and when you begin payouts, the more time your contract value has to grow.
Growth is not always guaranteed. It depends on the type of deferred annuity you choose.
How Does a Deferred Annuity Work?
A deferred annuity goes through two phases: the accumulation phase and the payout phase.
Accumulation Phase
During the accumulation phase, the value of your annuity may grow. How it grows depends on the type of deferred annuity you select.
Earnings grow tax-deferred during this phase. This means you do not pay taxes on earnings until you withdraw the funds.
Payout Phase
At the end of the accumulation phase, you can choose how to receive your money:
- Take a lump sum
- Annuitize the contract and receive regular income payments
If you take withdrawals at age 59½ or older, you can avoid the 10% early withdrawal penalty. Withdrawals are subject to ordinary income tax. If you take money out before age 59½, you may owe an additional 10% federal tax penalty.
Tax treatment depends on the type of annuity:
| Type of Annuity | How Withdrawals Are Taxed |
|---|---|
| Non-Qualified Annuity | Earnings are taxed as ordinary income. Early withdrawals before age 59½ may face a 10% penalty. |
| Tax-Qualified Annuity (such as an IRA annuity) | Withdrawals are generally taxed in full as ordinary income. Early withdrawals before age 59½ may face a 10% penalty. |
Some people use income from a deferred annuity to supplement other retirement income sources.
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Different Types of Deferred Annuities
There are several types of deferred annuities. Each works in a different way.
Fixed Annuities
With a fixed deferred annuity, growth is based on interest rates described in your annuity contract.
Your contract will outline:
- The guaranteed interest rate
- How long that rate applies
- How future interest rates are determined
A fixed annuity offers predictable growth based on the contract terms. However, if overall interest rates or inflation rise, your credited rate may not increase beyond what is stated in the contract.
Variable Annuities
With a variable annuity, growth depends on how you allocate your money among investment options called subaccounts.
These options may offer higher growth potential than a fixed annuity. However:
- Growth is not guaranteed
- The value of your contract can go up or down
- You could lose principal based on market performance
Past performance does not guarantee future results.
Fixed Indexed Annuities
A fixed indexed annuity credits interest based in part on the performance of a financial index. Your money is not invested directly in the stock market. Because of this, your return will not match the index exactly.
Key features may include:
- Protection from losses due to poor index performance
- Limits on how much of the index gain you receive
For example, a contract may include an 80% participation rate. If the index increases by 5%, your annuity would be credited with 4%.
Generally, indexed annuities carry more risk than fixed annuities, but less risk than variable annuities. The fixed annuity will have a minimum guaranteed rate of interest. With an index annuity, downside risk from the index is limited by the guarantee. A variable annuity could lose value from the variable options; though typically there is also a fixed option with a guaranteed interest rate.
Deferred Annuities & Preparing for Retirement
If you have reached the contribution limits for a 401(k) or an individual retirement account (IRA), you may consider a deferred annuity. Retirement accounts have annual contribution limits set by the IRS. Annuities do not have the same IRS contribution limits. This allows you to put in additional money beyond qualified plan limits.
Any earnings grow tax-deferred until you withdraw them. This may help increase the funds available to you in retirement. If you have questions about whether a deferred annuity fits your goals, consider speaking with a licensed financial professional.
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Footnotes
- An annuity is a long-term financial vehicle designed for retirement. An insurance company accepts premiums and provides future income or a lump-sum amount to the contract owner by contractual agreement.
