What a Deferred Annuity Is and How It Works

woman checking her online accounts
••• sturti / Getty Images

A deferred annuity is an account you can use to save money for when you retire. You don't pay taxes on it until you take money out. Unlike a 401(k) or IRA, there's no limit to the amount of money you can put in it in any single year.

With this annuity, you invest your funds with an insurance firm. You can choose between a fixed, variable, equity-indexed, or longevity annuity contract. The taxes on any money gains are put off until you take money out of the account. Any gain you withdraw before age 59 ½ will be subject to a 10% tax penalty. You will also have to pay income tax on the amount you withdraw. 

Your deferred annuity contract has an accumulation phase, which is when your money earns interest. It also has a payout phase, which is when you start taking lifetime payments. You're letting your earnings defer until you decide to turn the annuity into a secure stream of income.

Deferred annuities can come with all sorts of features (at a cost) that provide certain types of death benefits and/or future income guarantees. Here is an overview of the four main types of deferred annuities.

Fixed Deferred Annuity

A fixed deferred annuity works much like a certificate of deposit (CD). Instead of having to claim the interest income on your tax return each year, though, the interest is put off until you take money out of your annuity contract. When you purchase a deferred fixed annuity, the insurance firm will tell you the minimum interest rate your funds will earn. The insurance firm may pay more, but it won't pay less than the minimum.

For people who want to steer clear of risking their money and who will not need the interest income from their account until age 59½ or later, fixed annuities can be a good option. Before you buy a fixed annuity, compare the return being offered to other safe investment choices like CDs and government bonds.

Annuities are special because you are turning your money into a safe income for the rest of your life or for some other time you choose. To gain that safety, you earn a slightly lower rate that with other places you could put your money.

Variable Deferred Annuity

When you purchase a variable annuity, your funds are put into an investment account. You will decide how the funds are invested based on how much risk you can bear along with other factors. You choose from a pre-selected list of account types, which includes stocks and bonds. Your returns will vary depending on how the account performs.

Over the long haul and through most market ups and downs, you are likely to be better off buying into a portfolio of index mutual funds rather than a variable annuity for these reasons:

  • Because the things you invest in are inside an annuity, all taxes are put off until you take money out of your account. The tax deferral of a variable annuity is often touted as a good thing by people selling annuities. For some people, it could turn out to be a drawback. This would be true for people who may be in a higher tax bracket when they retire.
  • Annuity firms provide a whole array of features called riders. These riders can provide a death benefit and the promise of future income. They may come at a high cost that could erode your returns. Many annuities with these features are charging fees of over 3% a year. That said, depending on the rider, the extra costs may be worthwhile.

Equity-Indexed Annuity

An equity-indexed annuity functions like a fixed annuity in some ways and like a variable annuity in other ways. At its core, it's a type of fixed annuity.

Equity-indexed annuities have two parts. The first is a minimum guaranteed return. The second is the chance to earn a higher return based on a formula tied to a common stock market index like the S&P 500 Index. You can earn a certain amount of the index's growth, which is called a participation rate. If the S&P 500 grew by 10% in one year and you had a 60% participation rate, you would be credited 6% interest.

The downside to equity-indexed annuities is that they can be complex for some. They also often have high surrender charges that can last for 10 to 15 years. These charges are a fee you pay for taking out money during the early years of your contract. For instance, you might pay a 10% charge for taking out your funds within the first three years of your contract.

Longevity Annuity

When you buy a longevity annuity, it is like buying life insurance if you plan on living for a long time. You can start putting money into it even if you are near the time to retire. For instance, suppose at age 60, you deposit $100,000 in a longevity annuity. The insurance company guarantees you a certain amount of income for the rest of your life starting at age 85. This would leave you free to spend other assets, knowing you had the promise of a stream of income to support you later in life. The taxes and income on this type of annuity are put off until age 85 when you start taking the money out. If you died before age 85, the annuity would pass to your named beneficiaries.

Key Takeaways

  • Fixed deferred annuities promise a minimum rate return on the initial amount of money you put into it.
  • Variable deferred annuities don't offer guaranteed rates of return. How well they do is tied to the stock market.
  • Equity-indexed annuities combine features of the first two types. They have some level of guaranteed returns combined with some level of how they do in the stock market.
  • A longevity annuity doesn't kick in until well past the age you retire. The annuity can pass onto heirs if you die before reaching the longevity age.