Deferred Annuities

What is a Deferred Annuity?

Deferred annuities are secure financial tools that accrue interest over a long period of time. This annuity option allows annuity owners to customize their contract by choosing when to pay their premiums, when the annuitization period begins and how they want to receive their payments.

Unlike other annuity options, deferred annuities have an accumulation phase and an income phase. During the accumulation phase, owners pay a single premium payment or a series of periodic payments to their annuity account. The invested assets will then accrue interest, tax-free, for a defined period of time. During the income phase, annuity owners are able to customize their annuitization phase by choosing the disbursement frequency and how they receive their payments.

Accumulation Stage

Younger investors who have longer to save — and thus buy at a younger age — benefit the most from the accumulation stage of deferred annuities since they pay no taxes on interest until years later, usually after the age of 59½. Depending on the type of deferred annuity purchased, the interest can accumulate in four different ways:

• Fixed Rate – When fixed rate is chosen, your financial investment will accrue interest at a fixed rate that will not drop below a minimum rate, guaranteed by the issuing company. Before buying a fixed annuity, compare the return being offered to other low-risk investment choices.
• Variable Rate – With the variable rate option, insurers invest your premiums in mutual funds comprising stocks, bonds and other short-term money market products called sub-accounts. Your rate of return depends on the performance of your sub-accounts. This interest-earning rate is the most common for deferred annuities. Prior to purchasing a variable annuity, consider the risk of losing interest from your annuity savings.
• Equity-Indexed Rate – When an equity-indexed rate is employed, the companies tie your income to a market index such as the S&P 500 Composite Stock Price Index. They invest premiums in the stock and bond markets, and your contract guarantees a minimum interest rate that can’t drop – even if the stock market index falls. However, equity-indexed annuities tend to have higher surrender charges. Before purchasing, be sure to read the fine print and understand what surrender fees and other charges may accompany your equity-indexed annuity.
• Longevity Annuity – With longevity annuities, annuitants are guaranteed a specified amount of lifetime income payments once they reach the age of 80 or above, providing ample time for interest to accrue. Payments are tax-deferred until the annuitant reaches the designated payout age. Prior to purchasing a longevity annuity, weigh the benefits and risks of the delayed payout phase.

In the first nine months of 2014, combined sales for deferred income and fixed-rate deferred annuities reached $24.4 billion, according to LIMRA’s Secure Retirement Institute.

Distribution Stage

Once an annuitant reaches the distribution phase of their deferred annuity contract, which typically begins once the annuity owner reaches the age of 59½, they can receive income payouts in one of three ways:

• Lump Sum: In a lump sum disbursement, an annuity is distributed as a one-time, taxable single payment.
• Systematic Withdrawal: When funds are dispersed via systematic withdrawal, the annuity can be withdrawn or disbursed through periodic taxable payments. Any remaining assets continue to earn interest until the account has been depleted.
• Annuitization: Under an annuitization distribution plan, an annuitant receives monthly, quarterly or yearly distributions 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. Some of the major benefits of deferred annuities include:

• Tax-Deferred Investment: Annuitants only pay taxes once the money has been withdrawn. If the annuity was bought with pre-tax dollars, such as when you transfer funds from a 401(k) retirement plan into an annuity or purchase an annuity within your IRA plan at work, it’s considered qualified, meaning you pay taxes on both your principal and any interest you earn.
• Safety: Only insurance companies can sell annuities. (The nation’s top 25 insurance firms sell about 90 percent of all contracts.) Unless the company goes bankrupt, there’s little chance of losing your money. In addition, every state has an insurance guaranty association that protects investors in the unlikely event an insurer doesn’t honor its contractual obligations.
• 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.
• Bypassing Probate: Because a deferred annuity is an insurance product, you can leave it to your heirs without it going through probate. It’s a tax-free transfer.
• 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 IRAs and 401ks, the IRS places no upper limits on the principal amount you can contribute to a deferred annuity.
• Transfer to Immediate Annuity: This option allows you to move from the accumulation stage to the distribution stage without a waiting period, essentially transferring money from a deferred annuity to an immediate annuity. You sacrifice the ability to earn more interest by doing this, but you will have access to your principal and whatever interest was already generated.

On the other hand, there are some cons to a deferred annuity investment. Before signing a deferred annuity contract, you should be aware of certain drawbacks that affect your ability to access your money and may result in heavy charges, taxes and other fees:

• Lack of Liquidity: Annuitants are unable to withdraw any money from their annuity account during the contract’s first several years unless they pay a surrender charge for withdrawals. In addition, you’ll pay an IRS penalty for any withdrawal you make before you are at least 59½.
• High Tax Rates on Earnings: The IRS can tax annuity earnings at the ordinary income rate, which may be higher than the capital gains rate applied to investments in stocks, bonds and mutual funds held for more than one year.
• No Step-up Basis: Other investments like stocks, bonds and mutual funds receive a step-up in cost basis when you die, which can limit the tax liability for your heirs. Proceeds from most deferred annuities do not receive the same treatment, as they are taxable as ordinary income.
• Additional Expenses: Maintaining a deferred annuity contract can be expensive for all of the excess charges, including mortality and expense charges, administrative fees, funding expenses, charges for special features, riders (attached policy benefits) and high commissions for salespeople.

While owning a deferred annuity may have once been a profitable solution, financial needs change over time. If your deferred annuity has reached its income phase, you may be able to sell payments for money to help alleviate long-term debt.

Alanna Ritchie Staff Writer