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Deferred Annuity

As life expectancies continue to grow, many people are looking to supplement their existing financial strategies when determining how to save for retirement for longer periods. A deferred annuity is one tool that can serve just such a purpose. If you have several years until retirement, a deferred annuity could make sense for you.

Read on to learn more about how a deferred annuity works, how it differs from other types of annuities and whether or not it’s right for you.

Deferred Annuity Defined

A deferred annuity is a long-term investment in which you invest a sum of money, then receive payments several years down the line after the initial sum has accrued interest.

Unlike its counterpart, the immediate annuity, the deferred annuity has two distinct components: an investment phase and an income phase. The investment phase begins when you purchase the annuity, and it ends when you make your last contribution. You have the option to contribute to the annuity in one lump-sum payment or in several contributions over a longer period of time.

The income phase begins when you receive your first payment from your annuity. Just like the investment phase, you have a few options for how you would like to receive payments. You can receive everything at once in a lump-sum payment, or you can receive a set amount periodically until the annuity runs out of funds. You can also annuitize the fund to receive payments until you die.

A key feature of deferred annuities involves the manner in which they are taxed. Like many retirement accounts, you are able to contribute to your deferred annuity with pre-tax dollars. The funds will then be taxed as ordinary income once you withdraw them. To avoid a 10% penalty fee from the IRS, you’ll need to wait until age 59.5 before withdrawing anything.

In the event that you pass away before you’ve withdrawn all your funds, deferred annuity contracts will usually include a death benefit. This means a beneficiary of yours will receive the remaining funds after your death. The funds will still be taxed as ordinary income upon leaving the annuity.

Types of Deferred Annuities

When you purchase a deferred annuity, you will have to choose from among a fixed, variable or indexed annuity. Each option has unique pros and cons, so make sure to do your homework and choose the option that aligns most closely with your risk tolerance.

A fixed annuity is the most stable option, but it could also have a lower return. The interest rate is determined when you purchase the annuity, and it never changes.

With a variable annuity, you and your insurer will choose a dozen or more stocks, bonds or other money market funds and use their performance to determine the interest rate for the annuity. Variable annuities have the potential for high returns, but there is also risk of poor performance.

An indexed annuity is the most complex of the options. Like the fixed option, you have a minimum interest rate guarantee. How high the interest rate rises is determined by the performance of a market index like the S&P 500. Indexed annuities often have several stipulations that may limit your return.

Deferred Annuity vs. Immediate Annuity

Deferred Annuity

The difference between deferred annuities and immediate annuities is fairly self-explanatory. Immediate annuities begin paying out returns immediately. Deferred annuities sit undisturbed for years before you make any withdrawals.

Many deferred annuity contracts will have a process in place to convert into an immediate annuity should you need your money earlier than you expected. However, this option still may take several years to become available. It could also come with unpalatable fees. If you are purchasing a deferred annuity, you should plan on not seeing your money back for several years.

Should You Purchase A Deferred Annuity?

Like any annuity, or any retirement product for that matter, deferred annuities have their own unique benefits and drawbacks. Whether one is a good fit for you will depend on your retirement priorities as well as your risk tolerance.

Since only insurance companies can sell annuities, they are typically safe investments. Even in the rare case that an insurer goes bankrupt and can’t pay what it owes you, every state has insurance guaranty associations. They will help you get your investment back.

Another benefit is that the IRS has no upper limit on principal contributions to annuities. This sets the annuity apart from other retirement accounts like an IRA or a 401(k).

The biggest drawback to the deferred annuity is that your money is often untouchable for several years. Some, however, may see this as a benefit. Once you’ve finish contributing to your annuity, you’ll enter a surrender period. If a withdrawal during the surrender period exceeds 10%, the insurer will charge a surrender fee, typically between 7% and 15%. The fee will decrease by one percentage point each year until it reaches zero. Then, the surrender period will end. At that point you can make withdrawals without incurring a penalty. These fees are on top of the penalty from the IRS that will come if you make a withdrawal before age 59.5.

It’s also important to remember that once the income phase of your annuity begins, the IRS will tax the funds as ordinary income. This means your tax rate will be higher than any capital gains you could have accrued through other investment strategies.

Finally, purchasing an annuity can often bring with it several extra fees and expenses. Those include commissions for salespeople and various administrative fees.

The Takeaway

Deferred Annuity

If you are several years away from retirement and looking for a way to supplement your post-career income, a deferred annuity could suit your needs nicely. Just like any retirement account, however, you should make sure you’re aware of all the fees and stipulations. These could chip away at your returns.

If you choose to go forward with a deferred annuity, make sure you examine the contract closely to familiarize yourself with all conditions. In particular, review the details of any surrender period or death benefit.

Tips

  • In any retirement conversation, it’s always important to be mindful of the retirement tax laws in your state. Taking your state’s laws into account can make a significant difference as you plan for retirement.
  • Navigating the complexities of annuities can be a lot to keep straight. Finding a financial advisor who can explain the ins and outs of each option can reduce a lot of the headache of planning for retirement. With SmartAsset’s SmartAdvisor matching tool, you can answers a series of questions about your financial needs and preferences. Then, the tool will pair you with three financial advisors in your area.
  • Before you can save enough for retirement, you have to know how much you need in the first place. SmartAsset’s retirement calculator can help you determine how much you need to live the life you want in retirement.

 

Photo Credit: ©iStock.com/shapecharge, ©iStock.com/simonkr, ©iStock.com/PeopleImages

Hunter Kuffel, CEPF® Hunter Kuffel is a personal finance writer with expertise in savings, retirement and investing. Hunter is a Certified Educator in Personal Finance® (CEPF®) and a member of the Society for Advancing Business Editing and Writing. He graduated from the University of Notre Dame and currently lives in New York City.
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