What Is Deferred Annuities?
A deferred annuity is a contract between an individual and an insurance company where the annuitant makes payments, either a lump sum or a series of premiums, and in return, the insurer promises to make payments back to the annuitant at a future date. These financial products fall under the broader category of retirement planning and are designed for long-term savings and income generation. Unlike an immediate annuity, a deferred annuity has two distinct phases: an accumulation phase where the money grows on a tax-deferred basis, and a subsequent payout phase (or annuitization phase) when income payments begin. The primary purpose of a deferred annuity is to accumulate funds over time and then convert them into a steady stream of income, often for retirement.
History and Origin
The concept of annuities dates back to Roman times, where financial instruments called "annua" or annual stipends were sold, promising fixed yearly payments in exchange for a lump sum. The Roman Domitius Ulpianus is credited with creating one of the earliest life expectancy tables to support these arrangements. During the Middle Ages, annuities, including forms like the tontine, gained popularity in Europe as a means for governments to raise funds, particularly for wars, by promising lifetime income to contributors.21,20,19
While annuities have ancient roots, their widespread adoption as a modern financial instrument for personal retirement planning, especially the deferred annuity, largely evolved in the 20th century. In the United States, early forms of annuities were used by organizations like the Presbyterian Ministers Association in Pennsylvania to provide retirement programs, with figures like Benjamin Franklin advocating for their use.18 As traditional defined benefit plans became less common, and individuals assumed more responsibility for their own retirement savings, deferred annuities emerged as a tool to offer a guaranteed income stream, supplementing other savings like 401(k)s and IRAs.17
Key Takeaways
- A deferred annuity allows for tax-deferred growth during an accumulation phase before income payments begin.
- They are designed for long-term savings and provide a future stream of income, often for retirement.
- Deferred annuities can offer protection against longevity risk, ensuring income for life.
- Various fees, including surrender charges, and potential tax implications on withdrawals apply to deferred annuities.
- The value and payout of a deferred annuity depend on the type of annuity (fixed, variable, indexed) and the performance of underlying investment options.
Interpreting the Deferred Annuity
Interpreting a deferred annuity primarily involves understanding its two distinct periods: the accumulation phase and the payout phase. During the accumulation phase, the funds within the deferred annuity grow, typically on a tax-deferred basis, meaning no taxes are paid on the earnings until withdrawals begin. The growth rate depends on the type of deferred annuity purchased; for instance, a variable deferred annuity's value fluctuates with its underlying investments, while a fixed deferred annuity offers a guaranteed interest rate.16,15
The interpretation also involves assessing the flexibility and potential costs. Holders should consider factors such as the length of the surrender charge period, which dictates how long funds must remain in the annuity to avoid penalties for early withdrawal. Understanding the death benefit options and any living benefit riders is also crucial, as these features can significantly impact the annuity's value and utility in financial planning.
Hypothetical Example
Consider Sarah, a 45-year-old professional, who is looking to supplement her retirement savings beyond her 401(k). She decides to purchase a deferred annuity. She makes an initial lump-sum premium payment of $100,000. Sarah chooses a variable deferred annuity, allocating her funds among various subaccounts, similar to mutual funds. Over the next 20 years, during the accumulation phase, her annuity's value grows. Assuming an average annual net return of 6% after fees, her initial $100,000 could grow significantly.
When Sarah turns 65, she decides to annuitize her contract. If her annuity has grown to, say, $320,000, she then converts this accumulated sum into a stream of guaranteed income payments for the rest of her life. The exact amount of each payment would depend on factors like her age, gender, the annuitization option chosen (e.g., single life, joint life), and prevailing interest rates at the time of annuitization. This process illustrates how a deferred annuity can take a lump sum or series of payments and transform them into a reliable income stream during retirement.
Practical Applications
Deferred annuities serve several practical applications in personal finance and wealth management, particularly for those seeking long-term growth and a guaranteed income stream in retirement. They are commonly used by individuals who have maximized contributions to other tax-advantaged accounts like 401(k)s and IRAs, or those looking for additional tax-deferred growth.14
One significant application is bridging the income gap that might exist between an individual's Social Security benefits and any defined benefit plan or defined contribution plan payouts, and their desired retirement lifestyle. By annuitizing a deferred annuity, individuals can create a reliable, predictable income stream that lasts for their lifetime, helping to mitigate the risk of outliving their savings. The Internal Revenue Service (IRS) provides guidance on the taxation of annuity payments, including those from deferred annuities, in Publication 575, "Pension and Annuity Income."13,12 Furthermore, deferred annuities can also be utilized for estate planning purposes, with certain contract features allowing for a death benefit to be paid to beneficiaries.11,10
Limitations and Criticisms
While deferred annuities offer benefits like tax-deferred growth and guaranteed income, they also come with limitations and criticisms. A common concern is the array of fees associated with deferred annuities, which can include mortality and expense charges, administrative fees, and fees for optional riders.,9 These fees can significantly impact the overall returns, potentially eroding the benefits of tax deferral, especially if the annuity is not held for a long period.
Another major limitation is liquidity. Deferred annuities are designed for long-term investment, and withdrawing funds early often incurs substantial surrender charges imposed by the insurance company, in addition to potential tax penalties on earnings if the annuitant is under age 59½.,8 7The complexity of some deferred annuity contracts, particularly variable annuity products with numerous riders and investment options, can also be a point of criticism, making it challenging for investors to fully understand their terms and costs. The Financial Industry Regulatory Authority (FINRA) frequently issues investor alerts regarding the complexities and potential sales practice issues related to variable annuities, emphasizing the need for investors to understand all features, fees, and risks before purchasing.,6
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Deferred Annuities vs. Immediate Annuities
The fundamental difference between deferred annuities and immediate annuities lies in when income payments begin.
A deferred annuity, as discussed, has an accumulation phase where premiums are paid and the funds grow over time, typically tax-deferred, before the income payments start at a future date. This makes them suitable for individuals who are still working and saving for retirement, or those who want to delay receiving income for several years. The value of a deferred annuity can grow based on fixed interest rates, market performance (in the case of a variable annuity), or an index (for an indexed annuity).
In contrast, an immediate annuity (also known as an income annuity or single premium immediate annuity, SPIA) begins making regular income payments almost immediately after the lump-sum premium is paid. There is no accumulation phase; the annuitant starts receiving income within a short period, often within one payment period after purchase. Immediate annuities are generally chosen by individuals who are already in retirement or nearing it and want to convert a portion of their existing savings into a predictable income stream right away.
The confusion often arises because both are types of annuity contracts designed to provide income, but their timing and purpose in a financial plan differ significantly.
FAQs
Q: What is the main benefit of a deferred annuity?
A: The main benefit of a deferred annuity is its ability to provide tax-deferred growth on your invested funds during the accumulation phase, allowing your money to potentially grow more quickly than in a taxable account. It then converts these accumulated funds into a steady, often guaranteed, income stream in the future, providing financial security in retirement.
Q: Are deferred annuities taxable?
A: During the accumulation phase, earnings within a deferred annuity grow tax-deferred, meaning you do not pay taxes on the growth until you withdraw money or begin receiving income payments. When payments begin, a portion of each payment represents a return of your principal (which is tax-free) and a portion represents taxable earnings. The IRS provides detailed guidance on the taxation of annuity income in Publication 575.,4
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Q: Can I withdraw money from a deferred annuity before the payout phase?
A: Yes, it is generally possible to withdraw money from a deferred annuity before the payout phase begins. However, such withdrawals may be subject to surrender charges from the insurance company, especially if made within a specified surrender period (e.g., the first 5-10 years of the contract). Additionally, any earnings withdrawn before age 59½ may be subject to ordinary income tax and a 10% early withdrawal penalty.,
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1### Q: What happens to a deferred annuity if I pass away?
A: Most deferred annuities include a death benefit feature. If the annuitant passes away during the accumulation phase, the named beneficiaries typically receive the greater of the contract's accumulated value or the total premiums paid, often less any prior withdrawals. The specifics depend on the individual contract terms and chosen death benefit options.
Q: How does inflation affect deferred annuities?
A: Inflation can impact the purchasing power of future income payments from a deferred annuity, especially for fixed deferred annuities that provide a set payout amount. Some deferred annuities offer riders or features, such as cost-of-living adjustments or inflation protection, which can help mitigate this risk, though these often come with additional fees. Investors should consider how different annuity types address inflation when making a decision.