What Is a Deferred Annuity and How Does It Work?
Understand deferred annuities as a financial tool for long-term, tax-deferred savings and converting wealth into reliable future income.
A deferred annuity is a financial contract purchased from an insurance company for tax-deferred growth of long-term savings, primarily for retirement. It converts accumulated savings into a stream of income payments. The contract operates through two distinct periods: an initial accumulation phase and a subsequent payout, or annuitization, phase.
Core Components of a Deferred Annuity
The core of a deferred annuity involves two primary stages. The accumulation phase is where the contract owner contributes funds, either as a single lump sum or through periodic payments. These funds grow on a tax-deferred basis, meaning earnings are not subject to immediate taxation, allowing for potential compounding. The payout, or annuitization, phase begins when the accumulated funds convert into a series of regular income payments.
Key parties in a deferred annuity contract include the contract owner, who purchases the annuity and controls decisions like naming beneficiaries. The annuitant is the person whose life expectancy determines income payment duration; often, the owner and annuitant are the same individual. A beneficiary receives any remaining value upon the annuitant’s or owner’s death, depending on the contract’s specific terms. The issuing insurance company provides the contract and guarantees payments.
Different Kinds of Deferred Annuities
Deferred annuities vary in how funds grow and their risk levels. Fixed deferred annuities offer a guaranteed interest rate for a specified period or the contract’s life. They provide predictability and principal protection, with interest credited annually and compounding. The guaranteed rate offers a stable growth environment, similar to a certificate of deposit.
Variable deferred annuities fluctuate based on underlying investment options, often called “sub-accounts.” These sub-accounts are similar to mutual funds, offering higher growth potential but also investment risk, as the contract value can decrease with market downturns. Owners can change investment allocation without triggering a taxable event.
Indexed deferred annuities (FIAs) link returns to a market index, such as the S&P 500, without direct investment. They feature principal protection, safeguarding the contract value from market losses. However, upside potential is limited by features like participation rates, caps, and spreads, which determine how much of the index’s gain is credited.
Accumulation and Accessing Funds
During the accumulation phase, funds can be contributed as a single lump-sum payment or ongoing periodic payments. Funds can also be transferred from other retirement accounts, such as 401(k) or IRA rollovers.
Deferred annuities offer tax-deferred growth. Earnings, including interest, dividends, and capital gains, accumulate without current income tax until withdrawals begin. This deferral allows for enhanced compounding, as earnings grow without annual tax reduction, potentially leading to a larger accumulated sum.
Funds can be accessed during the accumulation phase, though annuities are designed for long-term savings. Withdrawals from non-qualified annuities follow a “Last In, First Out” (LIFO) tax rule, taxing earnings first as ordinary income. Withdrawals before age 59½ may also incur a 10% IRS penalty, in addition to regular income tax on earnings. This penalty aims to discourage using annuities for short-term savings.
Surrender charges are fees imposed by the insurance company if the owner withdraws more than a certain percentage or surrenders the contract during an initial “surrender period.” This period typically ranges from five to ten years, though it can vary. These charges are designed to help the insurance company recover sales commissions and administrative costs, and they typically decline gradually over the surrender period. Many contracts allow for penalty-free withdrawals of a small percentage, often up to 10% of the account value, annually.
Receiving Income Payments
Annuitization is the irrevocable conversion of the accumulated contract value into a guaranteed stream of periodic income payments. This marks the shift from saving to receiving regular income.
Several income payment options are available. A “Life Only” option provides payments for the annuitant’s lifetime, ceasing upon death. The “Life with Period Certain” option ensures payments for the annuitant’s life, but if the annuitant dies before a specified period (e.g., 10 or 20 years), payments continue to a beneficiary for the remainder of that period.
A “Joint and Survivor” option provides payments for two individuals, such as spouses, continuing to the survivor after the first dies, often at a reduced amount. A “Fixed Period” or “Period Certain” option makes payments for a specific number of years, regardless of the annuitant’s life or death.
A portion of each income payment from an annuitized contract is considered a tax-free return of principal. The remaining portion, representing earnings, is taxed as ordinary income. Once annuitized, the chosen payout structure is generally irreversible, making the selection of the income option a significant decision.