What Is A Deferred Annuity? How Do They Work? The Pros and Cons

Shawn Plummer

CEO, The Annuity Expert

A deferred annuity is an investment that allows you to save money for retirement. You make contributions to the annuity, and the money grows tax-deferred. This means you don’t have to pay income taxes on the growth until you withdraw the money from the account. Deferred annuities can be an excellent way to save for retirement, but there are some drawbacks that you should consider before investing in one. This guide will discuss a deferred annuity, how it works, and the pros and cons of investing in one.

What is a Deferred Annuity?

A deferred annuity is an investment that allows you to grow your money tax-deferred. This means you don’t have to pay taxes on your earnings until you withdraw the money, which is taxed as ordinary income. Deferred annuities can be a helpful way to save for retirement since they allow you to let your money grow without being taxed along the way.

There are two main types of deferred annuities: fixed and variable.

  • With a fixed deferred annuity, your earnings are guaranteed to grow at a set rate for a guaranteed period, similar to a Certificate of Deposit (CD).
  • In a variable deferred annuity, your earnings will fluctuate based on the performance of the underlying investments.
  • With index deferred annuities, your earnings can grow with a set rate or the performance of an underlying index (S&P 500, Nasdaq, Dow Jones) while protecting your principal.

Either way, deferred annuities offer a tax-advantaged way to save for the future.

These annuities are the opposite of immediate annuities.

How Do Deferred Annuities Work?

A deferred annuity is an insurance-based savings account used to save for retirement.

  • Accumulation Phase: During the accumulation phase, you make regular payments into the annuity, and the retirement savings grow on a tax-deferred basis. This means you do not have to pay income taxes on the earnings until you start taking future payments in retirement.
  • Distribution Phase: You can take regular payments or a lump sum withdrawal in the distribution phase. The future retirement income monthly payments will depend on the annuity terms and how long you have made payments.

Deferred annuities can be a great way to save for retirement and offer the potential for tax-deferred growth.

What Is The Benefit Of A Deferred Annuity?

A deferred annuity is an insurance contract that allows you to postpone receiving retirement income from your investment until a future date.

  • This type of annuity has several benefits, including tax-deferral and generating guaranteed retirement income for life.
  • Additionally, deferred annuities often offer inflation protection, which can help maintain the purchasing power of your guaranteed income in retirement.
  • Finally, some deferred annuities also offer long-term care benefits, which can help cover care costs if you need them in the future.

While many different types of annuities are available, a deferred annuity contract can be an appealing option for those looking for tax-advantaged growth and guaranteed income in retirement.

What Are The Drawbacks Of A Deferred Annuity?

A deferred annuity is a long-term investment that can be a great way to save for retirement. However, there are some potential drawbacks before investing in a deferred annuity.

  • One of the most significant drawbacks is the surrender charges that may be assessed if you withdraw all of your money early.
  • Another potential drawback is the fees associated with some (not all) deferred annuities. These fees can eat into your investment returns and reduce the overall growth of your investment.

Before investing in a deferred annuity, be sure to understand all the potential fees so that you can make an informed decision about whether or not it is right for you.

Deferred Annuity Pros And Cons

Pros

Cons

  • Deferred annuities are long-term contracts ranging from 2 to 20 years in length.
  • Some annuities charge hefty fees.
  • Liquidity is limited in annuities.
  • Annuity owners can’t collect income from their deferred annuity until age 59 ½ without being subject to a 10% tax penalty.
  • Annuity owners must fill out another application that could be approved or disapproved.

Is A Deferred Annuity A Good Investment?

A deferred annuity can be a great way to grow your savings while still having the protection of an insurance policy.

With a deferred annuity, you can choose to have your retirement savings invested for a set period of time and then receive payments (lump sum or series of payments) starting at a later date. This can provide upside potential if the market does well during the investment period. Still, it protects you from market downturns (except for variable deferred annuities).

In addition, there are no contribution limits with a deferred annuity, so you can put as much money into it as you want.

Plus, if you choose to receive payments starting at a later date, you can create a guaranteed income stream that will last for the rest of your life with lifetime deferred annuities.

And, since the earnings on a nonqualified deferred annuity are taxed only on the earnings, this can be a very tax-efficient way to save for retirement.

Use our deferred annuity calculator to estimate how much income you could receive in retirement.

Can You Lose Money With A Deferred Annuity?

When it comes to retirement planning, annuities are a popular option. They can offer a fixed stream of retirement income that can last for life and help protect your nest egg from market volatility.

However, not all deferred annuities are created equal.

  • Fixed indexed and fixed deferred annuities cannot lose money, even if the markets go down.
  • However, with a deferred variable annuity, your account value can go up or down, depending on how the underlying investments perform. As a result, you could potentially lose money with a variable annuity if the markets worsen.

If you’re considering an annuity as part of your retirement planning, be sure to contact us about the different types of annuities to learn about the income and investment guarantees and which one is right for you.

Tax-Deferred Annuity Types

There are two main types of deferred annuities: fixed and variable.

With fixed deferred annuities, you will earn a guaranteed interest rate on your money. This can be an excellent option for stability and predictable earnings.

With a variable deferred annuity, your earnings will fluctuate based on the performance of the underlying investment options. These types of deferred annuities can be a good choice if you are willing to take on more risk for the potential of higher returns.

Single-Premium Deferred Annuity

What is a single-premium deferred annuity? Single-premium deferred annuities (SPDA) are the type of annuities that can be purchased with one monetary deposit.

Flexible-Premium Deferred Annuity

Flexible-premium deferred annuities are tax-deferred annuity plans that allow an owner to contribute additional funds to an existing policy during the contract’s accumulation period. If funds are added to a flexible-premium annuity, the insurance company typically invests the added funds in a fixed account until the following anniversary or annual reset period.

How Do Interest Earnings Accumulate In a Deferred Annuity?

  • Fixed annuities guarantee your money will earn at least a minimum interest rate. Fixed annuities may earn interest at a rate higher than the minimum, but only the minimum rate is guaranteed. The insurance company sets the rates.
  • Fixed indexed annuities are fixed annuities that earn interest based on changes in a market index, which measures how the market or part of the market performs. The interest rate is guaranteed never to be less than zero, even if the market goes down. 
  • Variable annuities earn investment returns based on the performance of the investment portfolios, known as “subaccounts,” where you choose to put your money. The return earned in a variable annuity isn’t guaranteed. The value of the subaccounts you select could go up or down. If they go up, you could make money. But, if the value of these subaccounts goes down, you could lose money. Also, income payments to you could be less than you expected

Triple Compounding

Deferred annuities accumulate interest earnings on a tax-deferred basis, meaning taxes are not taken out until income is withdrawn from the annuity. As a result, triple compounding occurs, which is:

  • Earn interest on your principal
  • Earn interest on your interest
  • Earn interest on the money you usually lose to taxes

Features Of Deferred Annuities

Liquidity

Most deferred annuities allow for penalty-free withdrawals, systematic withdrawals, and waivers to assist in health-related issues like terminal illness, nursing homes, or home health care.

Annuitizing a deferred annuity gives up all control over the asset with no liquidity.

Death Benefit

The remaining accumulation value in deferred annuities will transfer to the beneficiaries in a lump sum. A spouse may continue the annuity through spousal continuation. Depending on how payments were structured, the beneficiary will receive either remaining annuity payments or no death benefit if the annuity has been annuitized.

Tax-Deferral

Deferred annuities offer tax advantages. Tax deferral means not paying federal income tax now but in the future when income is taken from the annuity.

Riders

Deferred annuities offer many types of optional riders, waivers, and benefits, including:

How Is A Deferred Annuity Different From An Annuity?

An annuity insurance contract provides lifetime income payments for a lump sum investment. There are two main types of annuities: immediate and deferred.

The main difference between deferred products and an immediate annuity is when the annuity owner starts receiving payments.

  • An immediate annuity begins making payments to the investor immediately, while a deferred annuity defers payments until later.
  • Both types of annuities can be either fixed or variable, but a deferred contract does not require annuitizing, which means converting the investment into periodic payments. Instead, the investor receives a lump sum payout at the end of the term.

This makes a deferred annuity ideal for those who want to build up their nest egg without worrying about making regular income payments.

Do You Pay Taxes On The Retirement Income From A Deferred Annuity?

Tax-deferred annuities allow your earnings to grow tax-free until you withdraw the money, at which point you will pay taxes on the earnings.

While deferred annuities tax benefits can be beneficial, it is crucial to understand that it is not the same as a tax-free investment, such as a Roth IRA or Roth IRA annuity.

With a tax-deferred annuity, you will eventually have to pay taxes on the money you withdraw, whereas, with a Roth IRA or Roth IRA annuity, you will never have to pay taxes on the money you withdraw. But, of course, early withdrawal taxes also apply as well.

Additionally, tax-deferred annuities can be either qualified or nonqualified.

Understanding the difference between these two types of annuities is essential before investing in one.

  • With a qualified deferred annuity, you are taxed on both the interest and the principal when you withdraw the money. A Roth IRA annuity is an exception to this taxation rule.
  • However, you are only taxed on the interest with a nonqualified deferred annuity.

Deferred Annuity At A Glance

Variable
Annuity
Fixed Index
Annuity
Fixed
Annuity
Immediate
Annuity
Deferred
Income
Annuity
Principal ProtectionNoYesYesYesYes
Access To PrincipalYesYesYesNoNo
Control Over MoneyYesYesYesNoNo
Tax-Deferred GrowthYesYesYesNoNo
Guaranteed GrowthNoYesYesNoNo
Guaranteed IncomeYesYesYesYesYes
Inflation ProtectionYesYesNoYesYes
Death BenefitYesYesYesYes/NoYes/No
Long-Term Care HelpYesYesYesNoNo

What Happens To Deferred Annuities When You Die?

One key consideration when deciding whether to invest in deferred annuity contracts is what will happen to the investment if you die.

With most deferred annuities, the death benefit is paid to your named beneficiary, either in a lump sum payment or installments. These death benefits can provide peace of mind knowing that your loved ones will receive some financial security after you’re gone.

However, it’s important to remember that the death benefit is typically paid out on a tax-deferred basis, which means your beneficiaries may have to pay taxes on the inheritance.

How Much Does A Deferred Annuity Cost?

Deferred contracts are insurance products that can provide you with a stream of future payments in retirement. However, before you purchase a deferred annuity, it’s essential to understand the costs associated with this type of product. The minimum investment for deferred annuity contracts is typically $10,000. 

How Do I Get A Deferred Annuity? 

If you’re looking for a deferred annuity, you can start by contacting an independent insurance agency (like The Annuity Expert), financial advisors, or any licensed financial professional. They can help you understand the different types of annuities and find one that fits your needs. You may also want to talk to an annuity expert to get their opinion on which annuity is best for you.

Once you’ve decided on an annuity, the next step is to purchase it. You can do this through an insurance company or a financial institution. Be sure to shop around and compare rates before you buy an annuity.

Finally, if you have a poor-performing annuity, don’t be afraid to sell it and reinvest the retirement savings in a better-performing one. With careful planning, a deferred annuity can be a great way to secure your financial future.

Next Steps

If you’re considering an annuity as part of your retirement planning, be sure to contact us about the different types of annuities and which one is right for you. We can help you understand the pros and cons of each type of annuity and find one that fits your needs. So give us a call today!

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Frequently Asked Questions

What is a deferred annuity, and example?

A deferred annuity is an investment vehicle that allows you to save for retirement. You make contributions to the annuity, which grows tax-deferred. You can either take a lump sum withdrawal or begin receiving income payments when you reach retirement age. There are two types of deferred annuities: fixed and variable.

What is the main difference between immediate and deferred annuities?

An immediate annuity pays benefits immediately, while a deferred annuity pays benefits at some point in the future. The main difference between the two is when you start receiving payments. Another difference between the two is how they grow. An immediate annuity doesn’t grow, while a deferred annuity does. This growth is tax-deferred, which means you don’t pay taxes on it until you withdraw the money.

How are deferred annuities calculated?

The formula for calculating a deferred annuity is future value = present value × (1 + interest rate)^number of periods.

For example, if you have $10,000 in a deferred annuity that pays 5% interest and you plan to leave it invested for ten years, the future value of the annuity would be:

$10,000 × (1 + 0.05)^10 = $16,105.05

Who needs a deferred annuity?

Deferred annuities are often used by people who are saving for retirement. The tax-deferred growth can make them an excellent way to grow your nest egg. And, since you don’t start receiving payments until later, you don’t have to worry about the effects of inflation on your purchasing power. Deferred annuities can also be an excellent way to create an income stream in retirement since you can choose to start receiving payments when you expect your other sources of income (such as Social Security) to start declining.

Can you lose money with a deferred annuity?

Yes, you can lose money with a deferred annuity if the interest rate on the annuity is lower than the inflation rate. This is because the purchasing power of your money will decline if it’s not keeping up with inflation. Also, if you withdraw money from a deferred annuity before age 59½, you may have to pay a 10% early withdrawal penalty. And, of course, you could lose money if the company that issues the annuity goes out of business. That’s why it’s important to research an insurer before buying an annuity. You can check an insurer’s financial strength rating at A.M. Best and Moody’s websites.

When should I buy a deferred annuity?

The best time to buy a deferred annuity is when you have the money you won’t need for at least seven years. This will give the annuity time to grow and compound without the risk of having to withdraw the money early. Also, remember that you may want to start taking Social Security benefits at age 62. It could reduce your Social Security benefits if you start receiving payments from a deferred annuity before that. So, you may consider waiting until after age 62 to start taking payments from a deferred annuity.

How soon can benefit payments begin with a deferred annuity?

With a deferred annuity, you can choose when you want payments to begin. The most common choice is at retirement, but you can also choose to start receiving payments before or after retirement in as little as 30 days. If you start taking payments before age 59½, you may have to pay a 10% early withdrawal penalty.

What are the basic types of deferred annuities?

There are two basic types of deferred annuities: fixed and variable. With a fixed deferred annuity, the interest rate is guaranteed for a set period of time, usually 2 to 10 years. After that, the interest rate may change, but it will never be lower than the guaranteed minimum rate. With a variable deferred annuity, the interest rate and your payments can go up or down, depending on how the investments in the annuity perform.

How many phases does a deferred annuity have?

A deferred annuity has two phases: the accumulation and payout phases. You contribute to the annuity during the accumulation phase, and the money grows tax-deferred. During the payout phase, you begin taking distributions from the annuity and pay taxes on the money as you withdraw it.

Can I cash out a deferred annuity?

Yes, you can cash out a deferred annuity, but you may have to pay a surrender fee and income taxes on the money. Also, if you withdraw money from a deferred annuity before age 59½, you may have to pay a 10% early withdrawal penalty.

Are fixed deferred annuities safe?

Yes, fixed deferred annuities are safe because the interest rate is guaranteed for a set period of time. However, the interest rate may change after the guarantee period ends, so some risk is involved.

What is an FPDA annuity?

An FPDA annuity is a flexible premium deferred annuity. This type of annuity allows the policyholder to make additional premium payments on an as-needed basis, up to a specific limit.

What is an SPDA annuity?

A single premium deferred annuity, or SPDA, is a type of investment that can provide financial security in retirement. With an SPDA, you make a one-time payment into the annuity, and the money is then invested for a period of time before it begins to pay out.

Shawn Plummer

CEO, The Annuity Expert

I’m a licensed financial professional focusing on annuities and insurance for more than a decade. My former role was training financial advisors, including for a Fortune Global 500 insurance company. I’ve been featured in Time Magazine, Yahoo! Finance, MSN, SmartAsset, Entrepreneur, Bloomberg, The Simple Dollar, U.S. News and World Report, and Women’s Health Magazine.

The Annuity Expert is an online insurance agency servicing consumers across the United States. My goal is to help you take the guesswork out of retirement planning or find the best insurance coverage at the cheapest rates for you. 

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