Deferred Annuity:
A deferred annuity is an insurance contract designed for long-term savings. Unlike an immediate annuity, which starts payments almost immediately, an insured can delay payments from a deferred annuity indefinitely. During that time, any earnings in the account are tax-deferred.
By using a deferred annuity, there are several options available for the insured.
- Adding funds to the account to increase the annuity’s value
- Taking lump-sum withdrawals as needed
- Transferring assets to a different financial institution
- Cashing out the annuity
- Converting the annuity into a stream of payments at a later date
- Leaving the assets to earn interest over time
Each option has fees or taxes which must be considered. There may be income taxes, penalty taxes, surrender charges to the annuity company, or other charges when funds are taken out of the annuity.
Annual fees are an important consideration of deferred annuities. Rider and sub-account management fees can amount to more than 1% of assets per year, so it is important for the client to consult with their tax professional as well.
How a Deferred Annuity Works
The term “annuity” refers to a series of payments. Traditionally, annuities provide lifetime income. When one uses a deferred annuity, the money can be turned into a systematic stream of income, or they can make withdrawals as needed, take it all out in one lump sum, or transfer the assets to a different annuity or account.
A deferred annuity allows one to keep control over the money and keep options open instead of irrevocably handing everything over to the insurance company in exchange for lifetime payments.
When used in that way, a deferred annuity is basically an account that also happens to have some of the features of an annuity: certain tax characteristics, and possibly guarantees made by an insurance company (including the possibility of a death benefit).
If a decision is made to annuitize, the insured can select a payment option from the insurance company’s list of choices. For example, they might choose to receive income that covers lifetime only, or might prefer to have payments continue for their lifetime or their spouse’s lifetime.
How Long Can Payments Be Delayed in a Deferred Annuity
The term “defer” refers to the fact that there is a waiting period to annuitize or take action on the annuity. Contrast that approach with an immediate annuity, which starts making payments more or less immediately after the annuity is purchased.
Once payments start being withdrawn from an immediate annuity, it’s difficult or impossible to stop the process and get the money back. With a deferred annuity, one can wait basically forever to being withdrawals.
How is Money Added to Deferred Annuities
Deferred annuities have an “accumulation phase,” which is the period of time before becoming fully annuitized. During that time, the insured can add funds to the account, assuming the insurance company and tax laws this. For example, the insured might make lump-sum or monthly contributions to the account or just leave it alone.
However, it’s crucial to understand all of the rules related to adding funds. For example, if the account is an IRA, the annual contribution limits and eligibility requirements for contributions may change yearly. The 2020 annual contribution limit for IRAs is $6,000 ($7,000 if one is over age 50).
How Can Money be Withdrawn from Deferred Annuities
After the accumulation phase comes the “payout phase” of the deferred annuity, which is when the insured can receive withdrawals. Withdrawals after age 59 1/2 won’t incur penalty charges. The annuity may be deferred indefinitely, or the insured can elect to receive payments in a number of different ways:
- Lump-sum, which is one, taxable payment
- Systematic withdrawal, in which taxable withdrawals are made periodically while the remaining funds earn interest
- Annuitization, which pays out regularly for a specified period of time, usually until the recipient’s or spouse’s death
How Does a Tax Deferral Differ From a Deferred Annuity
Don’t confuse the timing of payments from a deferred annuity with tax deferral, which is another feature available from annuities.
With tax deferral, one generally will not pay taxes on income inside of the annuity each year. Instead, the insured will only pay a tax when the earnings are removed from a tax-deferred account. Ideally, this allows a benefit from compounding. More money is kept in the contract, earnings can be reinvested, and earn more on top of those earnings.
The tax-deferral concept is similar to the idea of a deferred annuity. In both cases, something is put off for later, whether it’s when income is received from an annuity or when taxes are paid.