What Is a Deferred Annuity and How Does It Work?

A deferred annuity is a contract established with an insurance company, designed to grow savings over time and then provide a stream of income at a later date. It serves as a long-term savings and investment vehicle, primarily aimed at accumulating funds for retirement or other future financial needs. Individuals contribute money, which then grows on a tax-deferred basis until distributions begin.

The Two Phases of a Deferred Annuity

A deferred annuity progresses through two distinct periods: the accumulation phase and the annuitization phase. The accumulation phase begins when the annuity holder makes premium payments into the contract. These payments can be a single lump sum or a series of regular contributions over time. During this period, the money within the annuity grows through interest earnings or investment gains, with taxes on these earnings deferred until funds are withdrawn.

Once the accumulation phase concludes, the deferred annuity enters its annuitization phase, also referred to as the payout phase. This is the period when the accumulated value of the annuity is converted into a series of regular income payments to the annuity holder. The holder can choose when this phase begins, which typically aligns with their retirement or a specific future financial need.

Types of Deferred Annuities

Deferred annuities are categorized by how their accumulated value grows during the accumulation phase.

Fixed deferred annuities offer a guaranteed interest rate for a specified period, providing predictable growth and principal protection. The insurer declares an interest rate, often annually or for a multi-year term, ensuring a stable return on the invested premiums.

Variable deferred annuities link their growth to the performance of underlying investment subaccounts chosen by the annuity holder. These subaccounts operate much like mutual funds, investing in stocks, bonds, or money market instruments. While variable annuities offer the potential for higher returns, they also carry greater risk, as the contract’s value can fluctuate based on market conditions. The annuity holder bears the investment risk associated with these subaccounts.

Indexed deferred annuities, also known as fixed indexed annuities, represent a hybrid approach. Their growth is tied to the performance of a specific market index, such as the S&P 500, without directly investing in the index itself. These annuities incorporate features like participation rates, which determine how much of the index’s gain is credited to the annuity, and caps, which limit the maximum interest rate earned. They also typically include a “floor,” often 0%, ensuring the principal is protected from market downturns, balancing growth potential with downside protection.

Key Features and Mechanics

Premium payments can be a single, one-time contribution or flexible, periodic payments, depending on contract terms.

A common feature is surrender charges, which are fees imposed if the annuity holder withdraws funds or surrenders the contract entirely before a specified period, often ranging from six to ten years. These charges are designed to compensate the insurance company for expenses incurred in issuing the contract and typically decline over the surrender charge period. Annuity contracts generally allow for partial withdrawals, with most offering a “free withdrawal” provision, permitting access to a percentage of the contract value, typically 10% to 15% annually, without incurring surrender charges.

Many deferred annuities include a death benefit feature, which ensures that a designated beneficiary receives the accumulated value of the annuity, or a guaranteed minimum amount, upon the annuity holder’s death before annuitization begins. When the annuity holder chooses to annuitize, various payout options become available to convert the accumulated sum into income. These options include life income, which provides payments for the duration of the annuitant’s life (or joint lives), period certain, which guarantees payments for a specific number of years, or a combination of both.

Taxation of Deferred Annuities

The taxation of deferred annuities is a significant aspect of their financial appeal. Earnings within a deferred annuity grow on a tax-deferred basis, meaning that taxes are not levied on the interest or investment gains until funds are withdrawn or the annuitization phase begins. This allows the principal and earnings to compound more rapidly over time without annual tax erosion.

When withdrawals or income payments are made from a non-qualified deferred annuity (one held outside of a retirement account), they are taxed as ordinary income to the extent they represent gains. The Internal Revenue Service (IRS) generally applies a “Last-In, First-Out” (LIFO) rule to these withdrawals, meaning that earnings are considered to be withdrawn first and are therefore taxed before the return of principal. For instance, if an annuity has accumulated $50,000 in gains on an initial $100,000 contribution, the first $50,000 withdrawn would be fully taxable.

Additionally, withdrawals made from a deferred annuity before the holder reaches age 59½ are typically subject to an additional 10% early withdrawal penalty imposed by the IRS. This penalty is in addition to any ordinary income tax due on the taxable portion of the withdrawal. However, certain exceptions exist, such as withdrawals made due to disability, death of the annuity holder, or if the payments are part of a series of substantially equal periodic payments over the annuitant’s life expectancy.

Deferred annuities can be classified as either qualified or non-qualified. Qualified annuities are held within tax-advantaged retirement accounts like Individual Retirement Arrangements (IRAs), where all distributions are taxed as ordinary income. Non-qualified annuities, held outside such accounts, only tax the earnings portion of distributions.