What a Deferred Annuity Is and How It Works

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With a deferred annuity, you deposit your funds with an insurance company in a fixed, variable, equity-indexed, or longevity annuity contract. The taxes on any investment gains are deferred until you make a withdrawal. Any gain you withdraw before age 59 ½ will be subject to a 10% penalty tax in addition to ordinary income taxes. 

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. The payout phase is also called annuitization. Essentially, you're letting your earnings defer until you decide to turn the annuity into a guaranteed stream of income.

Deferred annuities can come with all sorts of features (at a cost) that provide specific types of death benefits and/or future income guarantees. Here is an overview of four main types of deferred annuities: fixed, variable, equity-indexed, and longevity.

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 deferred until you make a withdrawal from the annuity contract. When you purchase a deferred fixed annuity, the insurance company will tell you the guaranteed minimum interest rate your funds will earn. The insurance company may pay more, but it won't pay less than the minimum.

For risk-averse investors who will not need the interest income from their investment until age 59½ or later, fixed annuities can be an attractive option. Before you buy a fixed annuity, compare the return being offered to other safe investment choices like certificates of deposit (CDs) and government bonds.

Also consider the benefit that's unique to annuities: turning your money into a guaranteed income for the rest of your life or for another period you choose. That benefit may balance out a slightly lower interest rate.

Variable Deferred Annuity

When you purchase a variable deferred annuity, your funds are put into an investment account. You typically decide how the funds are invested based on your risk tolerance and other factors. You choose from a pre-selected list of investments, which typically includes stocks and bonds. Your investment returns will vary depending on the performance of those underlying investments.

Over the long haul, over most market conditions, investors are likely to be better off investing in a portfolio of index mutual funds rather than a variable annuity for the following reasons:

  • Because the investments are inside of an annuity, all taxes are deferred until you make a withdrawal. The tax deferral of a variable annuity is often touted as an advantage by annuity salespeople, but for many, it can actually turn out to be a disadvantage. Taxes may be higher in retirement, not lower.
  • Annuity companies provide a whole array of features called riders. These riders can provide death benefit guarantees and future income guarantees, often at high costs that erode your investment 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. Technically, it's a type of fixed annuity.

Equity-indexed annuities have two components: a minimum guaranteed return and the possibility of earning a higher return by crediting your account with a return based on a formula tied to a popular stock market index like the S&P 500 Index. You typically earn a percentage 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 confusing, and they often have high surrender charges (lasting 10 to 15 years). Surrender charges are a fee you pay for withdrawing money during the early years of an annuity contract. For example, you might pay a 10% surrender charge for withdrawing your funds within the first three years of your annuity contract.

Longevity Annuity

When you purchase a longevity annuity, it is like purchasing long life expectancy insurance. For example, suppose at age 60, you deposit $100,000 in a longevity annuity. The insurance company guarantees you a specified amount of life-long income starting at age 85. This would leave you free to spend other assets, knowing you had a guaranteed stream of income to support you later in life. The taxes and income on this type of annuity are deferred until age 85 when you start taking the money out. If you died before age 85, the annuity would pass to your named beneficiaries.