Is a Deferred Annuity a Good Investment?
Evaluate if a deferred annuity aligns with your financial goals and retirement planning. Understand its role as a long-term savings vehicle.
A deferred annuity is a contract with an insurance company designed to help individuals save for retirement and secure a future income stream. It serves as a long-term savings vehicle where funds grow over time before payments begin. This financial product can convert a sum of money into predictable income, appealing to those concerned about outliving their retirement savings.
Understanding Deferred Annuities
A deferred annuity is a financial contract from an insurance company providing income at a future date. It operates in two phases: accumulation and payout. During accumulation, funds grow tax-deferred. The payout phase begins when the owner elects to receive payments.
This differs from an immediate annuity, which starts payments soon after purchase. Deferred annuities have a waiting period, allowing capital to grow. They are suitable for those further from retirement.
Deferred annuities vary by how returns are determined. A fixed annuity offers a guaranteed interest rate, providing predictable growth. A variable annuity allows investment in sub-accounts, with value fluctuating based on performance, offering higher potential but also risk. Fixed indexed annuities are a hybrid, crediting interest based on a market index, with downside protection but limited upside.
Accumulation and Payout Mechanics
When the accumulation phase concludes, the annuity owner can transition into the payout phase, also known as annuitization, to receive income.
Common annuitization options include a life-only annuity, which provides payments for the annuitant’s entire life, ceasing upon death. This offers the highest periodic payments but leaves no benefits for beneficiaries. A period certain annuity guarantees payments for a specified number of years, even if the annuitant dies before the period ends.
Joint and survivor annuities provide income for two individuals, typically spouses, continuing payments to the survivor. Payout amounts depend on accumulated value, annuitant’s age, gender, and chosen option. Payments can also be structured as a lump sum or systematic withdrawals without formal annuitization.
Financial Aspects and Accessibility
Deferred annuities involve various fees and charges. Common fees include administrative fees (around 0.3% or flat), underlying investment fees for variable annuities (similar to mutual fund expense ratios), and mortality and expense (M&E) risk charges for variable annuities to cover guarantees.
Additional benefits, or riders, can be added for an extra cost (0.25% to 1% of value), such as guaranteed lifetime income or enhanced death benefits. Commissions paid to agents (1% to 8% of value) are typically built into the contract. Fixed-rate annuities generally have fewer fees.
Surrender charges are fees imposed if funds are withdrawn before a specified surrender period (several years to over a decade). These deter early withdrawals and help the insurer recover expenses. Charges are a percentage of the amount withdrawn, decreasing annually. Many annuities allow penalty-free withdrawals of a small percentage (e.g., 10%) each year.
Deferred annuities offer tax-deferred growth, meaning earnings are not taxed until withdrawals begin, allowing efficient compounding. Distributions are generally taxed as ordinary income. For non-qualified annuities, funded with after-tax dollars, only the earnings portion is taxed; original principal is not.
The Internal Revenue Service (IRS) applies a “last-in, first-out” (LIFO) rule to non-qualified annuity withdrawals. Earnings are considered withdrawn first and taxed before original principal. For example, if an annuity has $50,000 in earnings, the first $50,000 withdrawn is fully taxable. A 10% IRS penalty applies to the taxable portion if withdrawals occur before age 59½, unless an exception is met.
Considerations for Personal Financial Planning
Evaluating a deferred annuity involves assessing its alignment with individual circumstances and long-term objectives. A primary consideration is the time horizon for needing income, as deferred annuities are designed for long-term growth and future payouts. If income is needed soon, an immediate annuity might be more suitable. The longer the deferral period, the more time the annuity has to grow.
The need for guaranteed income in retirement is significant. Deferred annuities, especially fixed and fixed indexed types, can offer a predictable income stream, complementing other retirement income sources. This predictability provides financial security and helps mitigate the risk of outliving savings. However, guaranteed annuities may have lower growth potential than market-based investments.
Risk tolerance is also a factor. Fixed annuities offer principal protection and guaranteed rates for low-risk individuals. Variable annuities suit those comfortable with market volatility. Fixed indexed annuities offer market-linked growth with some downside protection.
Consider how a deferred annuity integrates into a broader financial portfolio. For those who have maximized tax-advantaged accounts, a non-qualified deferred annuity can provide another vehicle for tax-deferred growth without contribution limits. It can serve as a diversification tool, balancing other investments. The decision to purchase an annuity should be part of a comprehensive financial strategy.
The financial strength of the annuity provider is important. Annuities are contracts backed by the issuing insurance company’s ability to meet its future obligations. Research the financial ratings of the insurance company from independent agencies to ensure its stability and ability to deliver on contractual guarantees.