What Is a Tax-Deferred Annuity and How Does It Work?

An annuity represents a contractual agreement between an individual and an insurance company. This financial product functions as a long-term savings vehicle, primarily designed to generate a stream of income, particularly during retirement. A significant feature of many annuities is their tax-deferred growth, which allows accumulated earnings to grow without immediate taxation.

Core Concepts of Tax-Deferred Annuities

A tax-deferred annuity is a contract established with an insurance company where contributions and earnings are not taxed until withdrawals are made. Interest, dividends, and capital gains accumulate inside the annuity without annual income tax. The postponement of taxes allows the principal and earnings to compound more efficiently over time compared to accounts where investment gains are taxed each year. An annuity’s earnings compound on the full amount, untaxed, until funds are withdrawn, typically during retirement when an individual might be in a lower tax bracket.

Several key parties are involved in an annuity contract. The “contract owner” is the individual who purchases the annuity and controls the contract, including the right to make withdrawals or change beneficiaries. The “annuitant” is the person whose life expectancy determines the payout period, and who typically receives the income payments. The “beneficiary” is the individual or entity designated to receive any remaining value in the annuity upon the death of the annuitant or owner.

The initial payment or series of payments made into an annuity is known as the “premium.” Annuities often include a “surrender period,” a specified timeframe during which withdrawals above a certain percentage (often 10%) of the contract value may incur a “surrender charge.” This charge, designed to encourage long-term commitment, can be a percentage of the amount withdrawn, decreasing over the surrender period.

Most tax-deferred annuities are considered “non-qualified,” meaning that contributions are made with after-tax dollars. This distinguishes them from annuities held within qualified retirement plans, such as 401(k)s or IRAs, where contributions might be pre-tax. The after-tax nature of contributions in non-qualified annuities affects how distributions are taxed later, as the principal portion of withdrawals is generally not taxed again.

Main Types of Annuities

Annuities come in several forms, each offering different mechanisms for investment growth and varying levels of risk.

Fixed Annuities

Fixed annuities provide a guaranteed interest rate for a set period, offering predictable growth and protection of the principal investment. The insurance company assumes the investment risk with fixed annuities, making them suitable for individuals seeking stability and capital preservation.

Variable Annuities

Variable annuities allow the contract owner to allocate their premiums among various investment subaccounts, which are similar to mutual funds. The value of a variable annuity fluctuates based on the performance of these underlying investments, offering the potential for higher returns but also carrying greater market risk. These annuities typically involve various fees, such as mortality and expense charges, administrative fees, and investment management fees, which can impact overall returns.

Indexed Annuities

Indexed annuities, also known as fixed indexed annuities, link their growth to the performance of a specific market index, such as the S&P 500. While offering potential for market-linked gains, these annuities typically include features like caps, participation rates, or spreads that limit the maximum return. They also provide a measure of principal protection, shielding the investor from market downturns.

A fundamental distinction exists between immediate and deferred annuities. Immediate annuities begin making income payments shortly after the premium is paid, often within a year. Deferred annuities, which are the primary focus of tax deferral, allow the contributed funds to grow over an extended period before income payments commence.

The Annuity Lifecycle and Payouts

The lifecycle of a deferred annuity is typically divided into two main phases.

Accumulation Phase

The first is the accumulation phase, during which the contract owner contributes funds, either as a lump sum or through a series of payments. During this period, the money grows tax-deferred based on the annuity type—whether through guaranteed interest rates, market-linked returns, or investment subaccount performance. Contract owners can usually make additional contributions, particularly with flexible premium annuities, or simply allow the initial premium to grow. This phase is designed for long-term growth, often spanning many years leading up to retirement.

Payout Phase

The second phase is the annuitization or payout phase, where the accumulated funds are converted into a stream of income payments. This conversion can be initiated at a future date chosen by the contract owner and is generally irreversible once made, converting the accumulated value into a guaranteed income stream.

Several options are available for receiving income from an annuity.
A “lump sum withdrawal” allows the contract owner to take all accumulated funds at once, though this often triggers immediate taxation on all accumulated earnings.
“Systematic withdrawals” involve taking regular, fixed amounts from the annuity until the funds are depleted or for a specified period.

For annuitization, common payout options include:
“Life only,” which provides payments for the annuitant’s lifetime but ceases upon their death, offering the highest payment amount but no guarantees for beneficiaries.
“Life with period certain” ensures payments for the annuitant’s life, but if death occurs within a specified period, payments continue to a beneficiary for the remainder of that period.
A “joint and survivor” option provides payments as long as either the annuitant or a designated survivor is alive, typically resulting in lower individual payments but extended income security.

Taxation of Annuity Income

The tax treatment of annuity distributions is important. When withdrawals are made from a non-qualified annuity, only the earnings portion is subject to ordinary income tax rates, not capital gains rates. The original principal is returned tax-free.

The Internal Revenue Service (IRS) generally applies the “Last-In, First-Out” (LIFO) rule to withdrawals from non-qualified annuities. This rule dictates that any withdrawals are considered to come from earnings first, before any of the original principal. Consequently, early withdrawals are typically fully taxable as ordinary income until all accumulated earnings have been distributed.

An additional 10% federal income tax penalty generally applies to withdrawals made before the contract owner reaches age 59½. This penalty is imposed on the taxable portion of the withdrawal. However, certain exceptions exist, such as withdrawals made due to the owner’s death, disability, or if the annuity payments are part of a series of substantially equal periodic payments.

When an annuity is annuitized, meaning the accumulated funds are converted into a stream of regular payments, each payment is considered partly a tax-free return of principal and partly taxable earnings. This is determined by an “exclusion ratio,” which calculates the portion of each payment that represents a return of the original investment, ensuring the principal is not taxed again.

A “1035 exchange” allows for the tax-free transfer of funds from one annuity contract to another, or from a life insurance policy to an annuity. This provision under Section 1035 allows individuals to exchange contracts without triggering immediate taxation of gains, providing flexibility to switch annuity products or providers while maintaining the tax-deferred status.