How Deferred Annuities Work for Long-Term Saving

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A deferred annuity is an insurance contract designed for long-term savings. Unlike an immediate annuity, which starts annual or monthly payments almost immediately, investors can delay payments from a deferred annuity indefinitely. During that time, any earnings in the account are tax-deferred.

By using a deferred annuity, you keep several options available, including:

  1. Adding funds to the account to increase the annuity’s value
  2. Taking lump-sum withdrawals as needed (for significant expenses, for example)
  3. Transferring assets to a different financial institution
  4. Cashing out the annuity
  5. Converting the annuity into a stream of payments at a later date
  6. Leaving the assets to earn interest over time

Although all of the options above might be available, the consequences of those options cannot be ignored. You may have to pay income taxes, penalty taxes, surrender charges to the annuity company, or other charges when you take funds out of an annuity. As a result, it’s critical to learn about all of your alternatives—and review the details with a qualified tax professional—before you make any decisions.

How a Deferred Annuity Works

The term “annuity” refers to a series of payments. Traditionally, annuities provide lifetime income (retirement income, for example). When you use a deferred annuity, you don't necessarily ever have to turn the money into a systematic stream of income. Instead, you can simply make withdrawals as needed, take it all out in one lump-sum, or transfer the assets to a different annuity or account.

Ultimately, a deferred annuity allows you to keep control over the money and keep your options open instead of irrevocably handing everything over to the insurance company in exchange for lifetime payments.

When used in that way, a deferred annuity is basically an account that also happens to have some of the features of an annuity: certain tax characteristics, and possibly guarantees made by an insurance company (including the possibility of a death benefit).

If you eventually decide to annuitize, you can select a payment option from your insurance company’s list of choices. For example, you might choose to receive income that covers your lifetime only, or you might prefer to have payments continue for your lifetime or your spouse’s lifetime (whichever is longer).

How Long Payments Can Be Delayed in a Deferred Annuity

The term “defer” refers to the fact that you wait to annuitize or take action on the annuity. Contrast that approach with an immediate annuity, which starts making payments more or less immediately after you purchase and fund the annuity.

Once you start taking payments from an immediate annuity, it’s difficult or impossible to stop the process and get your money back. But with a deferred annuity, you wait—possibly forever—to annuitize your contract.

Adding Money to Deferred Annuities

Deferred annuities have an “accumulation phase,” which is the period of time before you annuitize (if ever). During that time, you can add funds to the account, assuming your insurance company and tax laws allow you to do so. For example, you might make lump-sum or monthly contributions to the account—or just leave it alone.

But it’s crucial to understand all of the rules related to adding funds. For example, if the account is an IRA, be mindful of annual contribution limits and eligibility requirements for contributions.

How a Tax Deferral Differs From a Deferred Annuity

Don’t confuse the timing of payments from a deferred annuity with tax deferral, which is another feature available from annuities. With tax deferral, you generally don’t pay taxes on income inside of the annuity each year. Instead, you pay tax only when the earnings are removed from a tax-deferred account. Ideally, this allows you to benefit from compounding: You keep more money in the contract, reinvest your earnings, and earn more on top of those earnings.

The tax-deferral concept is similar to the idea of a deferred annuity: In both cases, you put something off for later (whether it's when you receive income from an annuity or when you pay taxes).

Why It's Important to Seek Professional Advice Regarding Deferred Annuities

Speak with a tax advisor or Certified Public Accountant to determine the consequences of using annuities, as well as making withdrawals or transfers, before you do anything. This article is just a basic definition and does not go in-depth on these complex insurance products (and even more complicated tax laws).

Any guarantees are only as strong as the insurance company making the guarantee, and it is possible to lose money in an annuity. Consult with a local, licensed insurance agent for more details.