Deferred annuities are long-term retirement investments with tax incentives. They come with various drawbacks but do have some advantages, like utilizing time to earn interest.
Insurance companies provide these financial vehicles for people who have the ability to leave their savings untouched for a longer period of time to let the money earn interest. Buyers can customize their investment by choosing when they pay premiums and when and how they’ll get their money back.
What makes these annuities different is that they have an accumulation phase and an income phase. It depends on which phase the annuity is in whether owners can sell their payments for a lump sum.
During the accumulation phase, owners pay a single premium or series of them. Their money then earns interest, tax-free. The money sits in the tax-free account for a defined period of time.
During the income phase, owners choose the timing, amount and frequency of payments.
Making this product work to your advantage requires looking at interest calculations, money distribution schedules and whether they fit as a piece of your retirement plan. At times, people buy these as a retirement strategy only to discover they need to get their hands on their money much sooner than anticipated. (Why? Pick one: Divorce, sudden medical debt, the necessity to fund a child’s college education or any significant life change.) At that point, they inquire about selling their future payments to get their money now.
Selling Deferred Annuity Payments
You may be able to sell payments for money if your deferred annuity has reached the income phase.
If this tool is in the accumulation stage, the owner has access to liquidity by withdrawing directly from the account and paying surrender charges to the annuity issuing company.
For example, an investor purchases a $100,000 deferred annuity and leaves the money to earn interest for 15 years, after which the contract specifies that it reaches the income stage. During this stage, after accumulation is complete, the owner can sell payments.
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Younger investors who have longer to save– and thus buy at a younger age – benefit the most from the accumulation stage. That’s because they don’t pay taxes on the interest until years later, usually after age 59½.
Depending on the type of deferred annuity you purchased, the interest can accumulate in three different ways:
- Fixed rate: Insurance companies invest your premiums in company stocks and bonds. The company keeps the interest rate fixed for the first year and then resets it periodically but not below a minimum rate.
- Variable rate: Insurers invest your premiums in mutual funds comprised of 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.
- Indexed rate: 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.
Distribution starts at age 59½, and you receive payouts one of three ways:
- Lump Sum: You get your money in one large payment. Sounds good, but you immediately incur tax consequences.
- Systematic Withdrawal:You get your money through periodic payments. Money left over continues earning interest. You draw from your account until you deplete it.
- Annuitization: Under this distribution plan, you collect monthly distributions for A) the rest of your life; B) a specific number of years; or C) as long as you or your spouse live.
Deferred annuities attract investors because of their tax benefits, asset protection, lack of contribution levels and ability to pass to an heir.
- Tax-Deferred Investment: You only pay taxes once you collect your money, generally after you turn 59½. If you made your purchase with pre-tax dollars, it’s considered qualified, meaning you pay taxes on both your principal and any interest you earn. One bought with post-tax dollars is non-qualified. You only pay taxes on earnings from the principle. In both cases, you pay the IRS based on your current income tax rate.
- Safety: Only insurance companies can sell annuities. (The nation’s top 25 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 contracts have built-in guarantees against loss of principal or guaranteed rates of return.
- Lifetime Benefits: If you annuitize your contract, insurance companies guarantee lifetime payments for you or your spouse, no matter how long you live.
- Bypassing Probate: Because this is an insurance product, you can leave it to your heirs without it going through probate. It’s a tax-free transfer.
- Death Benefits: You can add a death benefit rider to your contract. This ensures that your surviving heirs receive your money if you die before your distribution phase kicks in. They would get any money that you (or your spouse) would have collected.
- No Contribution Limits: The IRS places no upper limits on the principal amount you can contribute. The IRA caps contribution levels for both IRAs and 401ks.
- Transfer to Immediate Annuity: This allows you to move from the accumulation stage to the distribution stage without a waiting period. 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.
Before you sign a 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: You can’t access any money in your account during the contract’s first several years unless you pay a surrender charge for withdrawals more than a certain percentage of the account balance. (The percentages can vary by contract.) In addition, if you are younger than 59½, you’ll pay an IRS penalty for any withdrawal you make.
- Risk: If you own an investment with a variable rate and did not purchase a rider guaranteeing your principal against loss, it is at risk.
- High Tax Rates on Earnings: The IRS taxes these earnings from at your ordinary income rate, which may be higher than the capital gains rate that applies 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.
- High Cost: These can be expensive because of mortality and expense charges, administrative fees, funding expenses, charges for special features and riders and high commissions for salespeople.
Many pre-retirees take advantage of deferred annuities. 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 (SRI).
If you already own a deferred annuity and need access to your money now, get a free quote from us. Our representatives can quickly provide you with a competitive estimate on cashing in your payments.