A deferred annuity is a financial product offered by an insurance company that allows you to invest money now to receive regular income payments in the future. They are commonly used as a tool to supplement retirement income, offering a reliable stream of funds to cover living expenses during retirement when traditional income sources, such as your salary, may no longer be available.
When purchasing an annuity from an insurance company, there are typically two main forms of annuities you can buy, an immediate annuity or a deferred annuity. Both types are typically purchased for their ability to generate a guaranteed income stream in retirement. However, only the deferred annuity includes an "accumulation phase" during which your annuity contract will have an opportunity to grow in value before income payments are initiated.
Unlike immediate annuities that are purchased with a single-lump sum payment and start paying out immediately after purchase, a deferred annuity can often be purchased through a lump-sum or with a series of payments and can allow you the flexibility to choose when you want to receive the income payments. This delay in income gives your funds the opportunity to grow over time, and potentially provides a larger income stream when you begin taking income from the contract.
Choosing the right annuity is important because there’s no one-size-fits-all solution. Before making your selection, it’s essential to understand the two other categories of deferred annuities: single premium and flexible premium. Whether you prefer the simplicity of a one-time payment or the flexibility of regular contributions, there’s a funding option for either approach.
A single premium deferred annuity is a financial product that can help you save for the future and provide a guaranteed stream of income later in life. Purchased through a lump-sum payment, your funds can grow tax-deferred over several years. After this period, you can initiate regular income payments that can last for a set period or the rest of your life, providing you with a reliable source of income during retirement.
A flexible premium deferred annuity is a financial product that allows you to make investments over time, rather than in one lump sum, and you delay receiving payments until a future date.
Prior to evaluating your deferred annuity options, it is important to understand the phases of an annuity. Deferred annuities typically have two phases:
Deferred annuities grow on a tax-deferred basis, and you will only pay taxes when you make a withdrawal, take a lump sum or begin receiving income from the contract*.
Now that you know a little about the different phases, let’s take a deeper dive into accumulation phase and how it works. The accumulation phase is the period in which you contribute to an annuity through a series of payments or a lump sum. During this period, the annuity has an opportunity to build value.
Ultimately, how the accumulation phase will work will depend on the type of deferred annuity selected and the features that are included. There are three common types of deferred annuities to choose from: fixed, indexed, and variable.
Variable annuities are a type of deferred annuity designed to accumulate contract value using mutual fund-like investment options. During the accumulation phase, payments are allocated to variable annuity subaccounts, which in turn invest in stocks, bond funds or money market funds. While they offer the potential for greater earnings compared to other types of annuities, variable annuities also come with greater investment risk and the potential for loss of your principal investment.
Fixed annuities are a type of deferred annuity designed to preserve and accumulate capital to carry into retirement. During the accumulation phase, your investment earns a guaranteed interest rate set by the insurance company. This rate will remain constant through the accumulation period or be locked in for a set period, depending on the annuity.
Indexed annuities are a type of deferred annuity designed to accumulate value by tracking a market index. Indexed annuities allow opportunity for your money to grow with downside protection to limit risk to your investment. During the accumulation phase, your investment can grow over time based on the performance of a specified market index, such as the S&P 500. Your principal is protected from negative returns with positive returns limited by a cap set by the insurance company.
The payout phase comes after the accumulation phase. It is also known as the annuitization phase. In this phase, the life insurance company distributes payments from the deferred annuity to the payee, typically the owner. These payments can be paid out in a lump sum over a set number of years, or for even the rest of your life.
A deferred annuity is a retirement investment vehicle that can offer benefits, including:
Despite its advantages, a deferred annuity can also have some drawbacks. Here are a few to consider:
If you are seeking to supplement your retirement income with a steady stream of payments, a deferred annuity might be worth consideration. Likewise, for those looking to defer taxes on investments gains and establish a reliable source of income for the future, a deferred annuity may align with these financial goals.
It’s important to evaluate your unique financial situation, risk tolerance and retirement objectives before purchasing any annuity. Consulting with a qualified financial professional can provide personalized guidance and help find a product that best fits your needs and objectives.
* Annuity payments from a tax-qualified plan will be fully taxable as ordinary income. Annuities are intended as vehicles for long-term retirement planning, which is why withdrawals reduce an annuity's remaining death benefit, contract value, cash surrender value and future earnings. Annuities also may be subject to income tax and, if taken prior to age 59 ½, an additional 10% IRS tax penalty may apply.
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