The major advantages to a tax-deferred annuity are accumulation and security. By putting off taxes until retirement, your annuity portfolio can use that money to maximize its returns. And then, in retirement, you receive a guaranteed income for life. The major disadvantages are returns and inflation, as these products tend to generate much lower rates of return than the market at large and their guaranteed income will lose its value over your retirement. Here’s how it works.
If you’re unsure about getting an annuity, a financial advisor can walk you through specific benefits and drawbacks for your retirement plan.
How Do Annuities Work?
In a nutshell, an annuity is a two-stage asset that you can typically buy from a life insurance company. During the first stage, you can invest over time in an account that builds value tax-free. This can be done by paying one or multiple premiums up front. Then, the second stage kicks in during retirement, when you start collecting payments from the annuity contract based on the overall value in that account. These payments will be structured according to the terms of the contract. And you will have to pay income tax on them.
One of the most popular types of annuities is a lifetime annuity. With this product, you can receive a series of guaranteed payments beginning in retirement and lasting for the rest of your life. The amount that you get is determined by your contract’s rate of return, which can be fixed or variable, and the amount you pay in premiums.
Broadly speaking, there are two categories of annuities: Immediate and deferred (or tax-deferred):
- With an immediate annuity, you make a single, lump-sum payment to buy the contract and begin to receive payments within one year of purchase. The more money you pay for this contract, the larger your guaranteed payments will be.
- With a deferred annuity, you purchase the contract in advance of when you want payments to begin. Then, over time, you make periodic contributions to the annuity account. The principal in your account earns interest at the rate set by your contract, creating a compound growth based on the account’s returns and your contributions.
Once you decide to begin collecting income, a step called “annuitization,” the insurance company starts issuing fixed payments based on the terms of the contract when you annuitize it.
How Are Deferred Annuities Taxed?
Ordinarily, the structure of an annuity account would suggest up front taxes. Since this is an interest-bearing account, you would typically pay income taxes on that interest for the year in which you receive it. You would then be free to withdraw the account’s combined principal and growth tax free at any time.
However, a tax-deferred annuity puts off that tax bill. With this product, you do not pay taxes on the interest in your annuity account for the year in which you receive it. These savings give your account more compounded principal with which to grow. In exchange, when you withdraw this money later in life you pay income taxes on your withdrawals. Whether you pay income taxes on the full withdrawal or just the accumulated interest depends on the annuity’s tax status.
Advantages of a Tax-Deferred Annuity
Tax-deferred annuities have two key advantages as investments and retirement products:
First, which is common to most annuities, is that it offers security. A standard lifetime annuity generates a guaranteed payment starting in retirement and lasting for the rest of your life. The value of these payments is based on the terms of the contract when you annuitize it. This means that, as long as you use a fixed-rate annuity, you can know your retirement income in advance based on your lifetime deposits. A significant risk to this product is if the company selling you the annuity defaults on its contract.
This can be a powerful advantage for retirement savings. Instead of worrying about consuming your retirement account and running out of money, you can effectively create a private pension fund for yourself.
The second advantage of a tax-deferred annuity has to do with accumulation. As a tax-deferred account, you don’t have to pay taxes on the interest you earn until it’s withdrawn. That lets your account grow more quickly, giving you extra principal so that you can maximize your compounding returns. And even though you will pay taxes on this money when you withdraw it during the payout phase, you can get larger payments thanks to the deferred taxes.
Disadvantages of a Tax-Deferred Annuity
Tax-deferred annuities also have two key disadvantages as investments and retirement products:
First, again common to most annuities, is that it may not be able to keep pace with inflation. While an annuity gives you security, the cost of living could go up faster than your fixed annuity payments.
At the Federal Reserve’s benchmark 2% inflation rates you can expect prices to double, and with a fixed-payment annuity your purchasing power to fall in half, about every 30 years. That isn’t necessarily a deal breaker, but it’s important to remember that if you rely on annuity payments alone you may see your standard of living slip as your costs of living climb.
The second disadvantage has to do with liquidity and returns. When you invest in a tax-deferred annuity, your money must stay in this account for minimum amount of time, typically until retirement. If you withdraw your money early you pay taxes and penalties.
This can be a challenge in and of itself, but the disadvantage is compounded by an annuity’s generally lower rates of return. Since this is an interest-bearing product, you can typically receive lower returns when compared with the market at large. And, if you change your mind and decide to pursue growth in the stock market instead, taking out your annuity money could cost you significant fees in surrender charges.
Tax-deferred annuities are financial products that allow individuals to invest money, with the earnings accumulating tax-deferred until withdrawals are made during retirement. This gives your account time to compound with interest. Though you will have to pay income tax on the money you get from the annuity later in life. And those payments could also fall behind inflation.
Retirement Tips for Beginners
- There are many types of annuities. This guide can help you determine whether fixed, variable, immediate, deferred, qualified, non-qualified or another type makes sense for your specific financial needs.
- A financial advisor can help you build a comprehensive retirement plan. SmartAsset’s free tool doesn’t have to be hard. SmartAsset’s free tool matches you with up to three 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.
Photo credit: ©iStock/fizkes, ©iStock/adamkaz, ©iStock/AaronAmat