Differences of Immediate vs. Deferred Annuities

The guaranteed income of an annuity makes it a valuable retirement product for many households. While there are many different types of annuities, two of the most popular are immediate vs. deferred contracts. With an immediate annuity, you buy the contract in a single lump sum and begin receiving payments immediately. A deferred annuity, on the other hand, lets you invest in the contract over time and begin receiving payments at a date in the future. This is what to consider when deciding between the two.

A financial advisor can help you decide on retirement options for your specific needs.

What Is an Annuity?

An annuity is a contract that you buy from a life insurance company or financial institution. You make one or more upfront payments in exchange for a guaranteed series of payments distributed over a set period of time. These payments are based on your annuity’s interest rate, so by the end of the contract’s repayment period, you will have collected more than your initial principal.

There are many different types of annuities. Some, for example, may offer fixed interest rates while others offer a variable rate of return. Some annuities set their payments in advance, while others pay based on the market at time of repayment. There are also some annuities that issue payments over a set period of time, such as five or 10 years, while others guarantee payments for the rest of your life.

Lifetime annuities are a popular asset for retirement investing. With a fixed lifetime annuity, you can receive a defined income stream throughout retirement. While the lack of growth means your annuity payments won’t keep up with rising inflation, they still provide a sense of security that few other retirement assets can match outside of a pension plan.

First, however, you must choose between an immediate vs. a deferred annuity contract.

What Is an Immediate Annuity?

Immediate annuities are bought with one lump-sum payment, and the contract begins issuing payments within 12 months of purchase. Depending on the specific annuity, you may be able to add more money to the contract during that 12-month period. However, most people pay for the entire annuity upfront.

For retirees, this is typically a purchase made when you retire, allowing you to cash out a portion of your portfolio to pay for an immediate stream of retirement income.

If the annuity is qualified, you can use funds from a pre-tax account to buy the annuity without paying taxes. You then pay income taxes on the annuity’s payments. If the annuity is non-qualified, you buy the annuity with after-tax money and then pay taxes only on the annuity’s returns.

You can still use funds from a pre-tax portfolio to buy this annuity, but you will have to treat those funds as a taxed withdrawal.

What Is a Deferred Annuity?

Deferred annuities are contracts that do not begin to make payments until more than 12 months after purchase. You can still use these as short-term contracts; for example, an annuity that begins payment 13 months after purchase would be considered a deferred annuity. However, most investors use these as long-term investment assets.

You can purchase a deferred annuity with either a lump-sum payment or through investments made over time. For example, say you spend $20,000 to purchase a deferred annuity that begins repayment in 20 years. You can either invest $20,000 upfront, or you can invest $1,000 annually until repayment.

A deferred annuity can have a fixed date when it begins repayment. Its repayment date can also be open-ended, based on when you choose to begin collecting.

For retirees, deferred annuities are generally part of a long-term retirement plan. Households will invest during their working years, allowing them to build up value in the annuity’s portfolio. They then can initiate repayment upon retirement.

As a bonus, you can invest in this contract with pre-tax funds if you purchase a qualified annuity.

Pros and Cons of Immediate vs. Deferred Annuities

A senior consulting a financial advisor about the benefits and drawbacks of annuities.

The major advantage of an immediate annuity is certainty.

With this contract, you know how much you have to invest and what the annuity will pay. You can take your savings and use that for the purchase price.

A fixed contract comes with set, predetermined payments. The insurance company will guarantee you a specific monthly payment for your lifetime or for a fixed amount of time in exchange for a set amount of money.If you have the funds upfront, you can easily make this contract part of your long-term retirement plans.

In particular, you can invest steadily over time, allowing you to build wealth year after year. Then, when it’s time to retire, you can begin repayment using the money you have accumulated. This allows you to get more out of your annuity by building wealth over time.

That said, it is also important to consider the contract’s long-term interest rate. When you invest in a deferred annuity, you put money in an interest-bearing account. If you choose a variable annuity, you deposit into sub-accounts that adjust based on investment performance. Either way, your money grows through a combination of interest payments and future investments.

When you trigger repayment, the annuity payments are calculated using the amount of your total savings and your life expectancy. In many ways, it is similar to purchasing an immediate annuity because both allow you to set the contract’s value based on the final lump-sum amount when payments begin.

The big question for investors is which option will generate the most generous payments. Based on the available annuity contracts, will you be better off saving your money in the long-term account of a deferred annuity? Or will you receive a better rate of return by investing in the market and using the proceeds to buy an immediate annuity at retirement?

To determine the best path for you, it is best to review your retirement plan with a financial advisor who can help you evaluate your options.

How to Choose Between Immediate and Deferred Annuities

Choosing between an immediate and a deferred annuity largely depends on your retirement timeline and income needs.

Retirement Income Stream

If you are already retired or plan to retire within the next year, an immediate annuity can provide a steady stream of income almost right away. These contracts are typically purchased with a single lump-sum payment and begin issuing monthly payments within 12 months.

Deferred annuities, in contrast, are better suited for individuals who are still working or saving and want to build future retirement income. They allow time for your funds to grow before payouts begin so you can receive higher payments later in life.

Interest Rates

The interest rate environment is another factor that can influence which type of annuity makes most sense. Immediate annuity payouts are based on prevailing interest rates and your life expectancy at the time of purchase. When rates are high, buyers can lock in more favorable income streams.

Deferred annuities, on the other hand, can benefit from long-term compounding if interest rates or investment returns rise during the accumulation period. However, if rates remain low, the growth advantage of deferral may be smaller. Evaluating market conditions and rate trends can help determine which approach is more advantageous.

Age and Life Expectancy

Your age and life expectancy also play a significant role in the decision.

An immediate annuity may make more sense for someone who wants financial security and expects to rely heavily on predictable income during retirement. Meanwhile, a deferred annuity may be more appropriate for those who anticipate a longer lifespan and want to supplement future income or delay withdrawals until later years.

Health

Health status is also relevant. Individuals in poor health with a lower life expectancy may not benefit as much from lifetime payouts, while healthier retirees may gain more from deferral and long-term growth.

Taxes

Tax considerations are another key element.

Immediate annuities purchased with pre-tax funds from accounts like traditional IRAs will generate taxable income as payments are received. Deferred annuities allow for tax-deferred growth, with taxes due only when distributions begin. This deferral can be useful for individuals in their peak earning years who want to postpone taxable income until retirement in case they fall into a lower tax bracket. Meanwhile, using after-tax funds for a non-qualified annuity allows a portion of each payment to be treated as a tax-free return of principal.

Financial Goals

It is also important to look at how either annuity fits into your broader financial plan.

An immediate annuity can asa reliable basis of guaranteed income alongside your Social Security or pensions, while a deferred annuity can act as a supplement to long-term savings or as a hedge against longevity risk.

Reviewing expected expenses and other income sources can help you make the right choice. It is also important to consider your comfort with locking up funds for an extended period.

A well-structured plan may even include both types, using immediate annuities for near-term security while deferred annuities provide future income growth.

Bottom Line

A woman researching the benefits of getting a deferred annuity.

An immediate annuity is a contract that begins repayment within 12 months of purchase and is typically bought with a single lump-sum payment. A deferred annuity, on the other hand, is a contract that begins repayment more than 12 months after purchase and is bought with either a single lump-sum payment or through a series of investments over time.

Annuity Planning Tips

Annuities are popular retirement assets for a reason. They provide a sense of stability that only pension plans and Social Security can match. This guide can help you calculate how much an annuity could pay.
A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.