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A deferred annuity is an insurance contract that guarantees income at a future date. Deferred annuities differ from immediate annuities, which begin making payments right away, in that income payments are delayed until the date specified in the insurance contract. Earnings on the premium grow tax-deferred until the money is withdrawn.
When you purchase an annuity, if you decide to start receiving payments within a year, you have an immediate annuity. Should you decide to wait to collect or at some point in the future, you have a deferred annuity.
Deferred annuities allow your principal to increase before you begin to receive the stream of payments. Typically, annuities, such as qualified longevity annuity contracts, are bought for future retirement income.
According to the LIMRA Secure Retirement Institute, deferred annuities are forecast to have the largest growth rates over the coming years.
Accumulation and Payout Phases
There are two phases to a deferred annuity: The accumulation phase and the payout phase.
During the accumulation phase, you are making payments and your annuity is accumulating interest on a tax-deferred basis. How this accumulation occurs varies depending on the annuity type.
Variable annuity contracts allow insurers to invest your premiums in mutual funds that comprise stocks, bonds and other short-term money market products called “sub-accounts.” Your rate of return depends on the performance of your sub-accounts.
Indexed annuities are tied to the performance of stock-market measurements, including Standard & Poor’s index of 500 stocks, commonly known as the S&P 500. Your contract guarantees a minimum interest rate — even if the performance of the stock market index declines.
If you die during the accumulation period, a deferred annuity includes a basic death benefit that pays some or all of the value of the annuity to your beneficiaries.
You don’t pay taxes on those earnings during the accumulation phase. Taxes are not due until you reach the payout phase.
If you die during the payout phase, your beneficiaries may not receive anything unless you have a specific provision in your annuity contract providing for your beneficiaries to be paid.
Single Premium Deferred Annuity vs. Flexible Premium Deferred Annuity
Deferred annuities are also classified according to how you pay for them. You can make one payment or several. And if you make several payments, they can be structured in different ways.
Single Premium Deferred Annuities
Single premium deferred annuities are purchased with one sum of money in one payment.
Unlike premiums for immediate annuities, which must be paid in one installment, premiums for deferred annuities can be spread over time in a series of payments.
There are advantages and disadvantages with single premium deferred annuities. For example, a single premium deferred annuity might tie up more of your money than you ultimately could afford to put into it, which could wind up costing you a surrender fee.
- Guaranteed rate of return
- Principal protection
- Potential surrender charges
- Lack of capital for investments (opportunity cost)
Flexible Premium Deferred Annuities
A flexible premium annuity is a type of deferred annuity that is purchased with a series of payments. These payments can be scheduled as specific amounts — what’s known as scheduled premium deferred annuities — or they can change according to your plans or ability to pay.
A deferred annuity that allows you to adjust your payments in this way is known as a flexible premium deferred annuity.
- Less capital tied up
- More time to pay for the product best suited to you
- Rate of return not guaranteed
- Potential contribution limits
Once an annuitant reaches the distribution phase of their contract, which typically begins when they reach the age of 59 and a half, they can receive payouts from the annuity in one of three ways.
In a lump-sum disbursement, an annuity is distributed as a one-time, taxable single payment.
When funds are dispersed via systematic withdrawal, the annuity can be withdrawn or disbursed through periodic taxable payments. Any remaining money continues to earn interest until the account has been depleted.
Under an annuitization distribution plan, an annuitant receives monthly, quarterly or yearly payments for a designated amount of time, until the annuitant’s death or until the annuitant’s spouse dies.
Pros and Cons of Deferred Annuities
As with any investment, deferred annuities carry a number of benefits and risks.
- Tax-Deferred Investment
- Owners do not pay taxes during the accumulation phase. Taxes apply once the distribution phase begins and the owner starts to receive payments.
- Guarantees Against Loss
- Most deferred annuity contracts have built-in guarantees against loss of principal or offer guaranteed rates of return.
- Lifetime Benefits
- If you annuitize your contract, insurance companies guarantee lifetime payments for you or your spouse until your deaths.
- Death Benefits
- Deferred annuity contracts include a death benefit component. This ensures that any surviving heirs receive any remaining assets if you die before the end of the annuity contract.
- No Contribution Limits
- Unlike with IRAs and 401ks, the IRS places no limits on the principal amount you can contribute to a deferred annuity.
- Lack of Liquidity
- Annuitants are unable to withdraw any money from their annuity during the contract’s first several years unless they pay a surrender charge for withdrawals. In addition, you’ll pay a penalty to the Internal Revenue Service for any withdrawal you make before you are at least 59 and a half.
- High Tax Rates on Earnings
- Because annuity contracts grow on a tax-deferred basis, the IRS taxes annuity earnings at the ordinary income rate, which may be higher than the capital gains rate applied stocks, mutual funds and exchange traded funds.
- Additional Expenses
- Maintaining a deferred annuity contract can be expensive due to administrative fees, funding expenses, charges for special features and riders, and commissions.
8 Cited Research Articles
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- Bloink, R. & Byrnes, W.H. (2017, February 17). Single Premium Deferred Annuities: One Size Does Not Fit All. Retrieved from https://www.thinkadvisor.com/2017/02/17/single-premium-deferred-annuities-one-size-does-no/
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