What Is a Deferred Annuity & How Does It Work?
Learn what a deferred annuity is and how it functions as a financial tool to build future income. Explore its types and features.
Annuities are financial products providing a steady income stream, often used in retirement planning. They represent a contract between an individual and an insurance company, where the individual makes payments, and in return, receives regular disbursements at a later date. This article focuses specifically on deferred annuities, exploring their structure, various forms, and the common features associated with them.
Understanding Deferred Annuities
A deferred annuity is a contract with an insurance company that allows funds to grow over a period before they are converted into a series of income payments. Unlike an immediate annuity, which begins payouts almost directly after purchase, a deferred annuity includes a substantial period where the money accumulates. This delay allows funds to increase in value before income payments begin.
This financial product operates in two distinct phases. The first is the accumulation phase, during which the individual makes premium payments into the annuity. During this period, funds grow on a tax-deferred basis, meaning that earnings, such as interest or investment gains, are not subject to current income taxes. This allows the balance to compound over time.
The second phase is the annuitization or payout phase, which begins when the accumulated funds are converted into a stream of regular income payments. The annuitant can choose from various payout options, such as receiving payments for a fixed period or for their lifetime. Payments can be structured for a single life or for the joint lives of the annuitant and another individual.
Types of Deferred Annuities
Deferred annuities come in several forms, each offering different approaches to how the money grows during the accumulation phase. These variations cater to different risk tolerances and financial objectives.
A fixed deferred annuity provides a guaranteed interest rate on the premium payments. This type of annuity offers predictable growth and protection of the principal investment, making it suitable for individuals seeking stability. The insurance company guarantees a minimum interest rate for a set period, providing a clear expectation of returns.
A variable deferred annuity allows the annuity owner to invest their premiums in various underlying investment options, often referred to as sub-accounts. The value of the annuity in this type fluctuates based on the performance of these chosen investments. While variable annuities offer the potential for higher returns, they also carry a greater degree of market risk, as the value can decrease if the investments perform poorly.
An indexed deferred annuity, also called a fixed indexed annuity, links its growth to a market index, such as the S&P 500. This type typically includes a cap on potential gains, limiting how much the annuity can earn even if the index performs exceptionally well. However, it also usually provides a floor, which protects the principal from market losses, offering a balance between growth potential and risk mitigation.
Key Features and Considerations
Deferred annuities incorporate several common features. Premiums for a deferred annuity can be paid in different ways. An individual might make a single, lump-sum payment to fund the annuity contract entirely at the outset. Alternatively, a flexible premium deferred annuity allows for multiple periodic payments over time, providing more flexibility for ongoing contributions.
A significant characteristic of deferred annuities is their tax-deferred growth. Taxes on these gains are only incurred when withdrawals are made or when income payments begin in the payout phase, at which point they are generally taxed as ordinary income.
Many deferred annuities include surrender charges, which are fees imposed if money is withdrawn from the annuity before a specified period, known as the surrender period, has ended. These charges typically decline over several years. Larger or earlier withdrawals typically incur these charges.
A death benefit is often a feature of deferred annuities, providing a financial payout to designated beneficiaries if the annuitant passes away during the accumulation phase. This benefit typically ensures that beneficiaries receive at least the amount of premiums paid or the accumulated account value, depending on the contract terms. Furthermore, optional riders can be added to an annuity contract for an additional cost. These riders can enhance features like guaranteed income benefits or provide an increased death benefit, tailoring the annuity to specific needs.