Should you buy a deferred annuity? Pros & cons

Retirement is a chance to focus on the activities you love. To get the most out of this life stage, you need income sources you can rely on. An annuity could help to fill that need, and a deferred annuity in particular could be a great complement to your overall retirement strategy.

As you decide if you should buy a deferred annuity, there are benefits and drawbacks to think through. They offer a few different payout options and some tax advantages, but they're also not designed for quick cash withdrawal.

Let's explore how these products work, the different types of deferred annuities to evaluate and some considerations to weigh before buying one.

All annuities are contracts that have the option to guarantee income stream in retirement. You pay an insurance company a premium, and the insurer agrees to make annuity payments back to you.

With deferred annuities, the payout phase—or annuitization—doesn't start until a future date. Before then, the money generally can't be withdrawn without paying fee or surrender charges, but any interest or investment growth is tax-deferred until you make a withdrawal or begin receiving the payouts. It's this time-delayed, tax-advantaged aspect of deferred annuities that makes it such a useful retirement tool. Many people start paying premiums for deferred annuities during their working years—the accumulation phase—and plan to use the annuity payments to supplement their income when they're retired—the payout phase.

You usually can choose whether your deferred annuity payouts are made over a set period of time, such as 10 years, or for the rest of your life. Opting for a lifetime income stream may ease concerns about outliving all your retirement money.

While there are a variety of deferred annuities to consider, they're commonly categorized as fixed or variable. With each, the insurer offers a different way of paying interest or calculating gains on the annuity's value. The kind of deferred annuity you might choose largely comes down to what fits with your overall retirement strategy and risk tolerance.

One common thread among fixed annuities is that your principal can't lose value due to market losses, which makes them attractive for those who are in or near retirement. There are three main versions, depending on your retirement timeline and income needs.

Fixed annuities guarantee a specific rate for a set period of time. The rate will depend on the prevailing rates when you sign your application.

You might choose a fixed annuity if your primary goal is preserving assets because your principal amount won't decrease. Fixed annuities have a guaranteed minimum interest rate for the life of the contract, offering a current rate that typically changes once a year.

Multi-year guarantee annuities, or MYGAs, also offer a guaranteed interest rate but for a specific number of years. For that reason, they're often compared to CDs, although they're not bank products and they have other differences as well.

At the end of the guarantee period, most insurers allow you to renew your contract at current interest rates. If you decline that offer, you can typically surrender your contract without penalty or transfer your funds to another annuity. A MYGA may be a good choice if you're looking for predictable growth for a specific period of time.

With a fixed indexed annuity, the value of the contract is linked to a specific index, such as the S&P 500, but they come with a cap on the potential interest you can earn. While this may limit your positive performance if the market is up, it offers protection from market losses if the index drops in value.

For example, if the index linked to your annuity grows by 8% in a given year and your annuity has a 4% cap, the insurer will only credit 4%. If the index grows by an amount less than the cap, you'll get interest applied equal to the index return. And if the index return is zero or negative, your annuity value just will stay flat.

Variable annuities offer greater growth potential and a larger degree of risk. You'll select investment subaccounts—essentially a basket of stocks, bonds or other assets—based on your financial goals and risk tolerance among other factors. Your annuity’s value will fluctuate daily based on the performance of the subaccounts you select.

This feature allows you to invest your annuity’s value in the market. You have greater growth potential than a fixed annuity but a greater chance of loss if your subaccounts drop in value. But generally, the longer you defer your payout stage, the more time you have for assets to recover from a market downturn. Variable annuities can be a sound choice for a portion of your retirement fund, if you have several years before you want the payout phase to begin or you have a higher tolerance for risk.

A deferred income annuity provides you with preset payments that begin at a specified point in time that you select at the time of application—typically more than a year or up to 40 years away.

A deferred income annuity often is used to insure an income late in life. You decide ahead of time when you think it will make the most sense for your payouts to begin given your health and family history. For example, if you think you'll have enough assets in place to last you through age 85 but you also expect to have a very long life, you may decide to purchase an annuity that starts paying out after that age.

These annuities involve neither specified fixed nor variable rates of return for you. Instead, you pay the premium, and after the allotted period of time, the insurer makes payments of a fixed amount back to you. They have the potential to exceed what you paid in since the payments are guaranteed for as long as you live.

Reduced liquidity is one of the risks of a deferred income annuity that should be considered before purchase. Most of these products do not allow for any withdrawals during the deferral period. During the income period you only can receive the income you elected and have no ability to make unscheduled withdrawals.

Most deferred income annuities have no death benefit and stop making payments when you pass away, but there are many options to explore. Some provide that if you die before the annuity has paid out at least as much as the premium you paid in, your beneficiaries can receive the remaining amount as periodic payments or a lump-sum payout.

Deferred annuities can offer several potential advantages, regardless of the type you choose. Consider these benefits as you decide whether to add deferred annuities to your retirement strategy:

With deferred annuities, any earnings received during the accumulation phase grow on a tax-deferred basis. (Although with a variable annuity, which is tied to investment subaccounts, growth is not guaranteed.) You won't pay ordinary income taxes on your annuity gains until you receive the payouts. This is similar to how 401(k)s and traditional IRAs work and can translate into a larger return after taxes.

This "tax later" feature is in contrast to the "tax now" aspect of accounts where you have to pay taxes annually.

When you head into retirement, there is the possibility of outliving your assets—known as "longevity risk." When you elect a lifetime annuity payout, you can protect your finances by transferring that risk to the insurer. The annuity payments effectively become your new paycheck, providing a reliable income source that lasts.

A deferred annuity typically has a death benefit where the insurance company will return at least the premium amount to your beneficiary. Your beneficiaries would receive this death benefit if you pass away before your annuity’s value is depleted. This feature ensures that your loved ones will benefit from the premiums you already paid. Once you elect an annuity payout, the death benefit will depend on the option you selected.

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While deferred annuities can be a way to guarantee your retirement income, you'll want to think through the potential risks as well.

With the delayed payout phase, a deferred annuity isn't designed for you to be able to tap into your funds early. Most annuities have a surrender charge if you withdraw money before a certain period of years. This time frame varies depending on the type of annuity but can be up to nine years after your purchase.

The IRS may also levy a penalty tax if you withdraw from an annuity before age 59½. You'll have to pay a 10% penalty on any gains you withdraw early on top of paying income tax.

Variable annuities have contract and portfolio fees. Variable and fixed annuities also may have charges for optional benefits and riders. In addition, some multi-year guarantee annuities have what is called a market value adjustment (MVA) feature if you withdraw money before the selected guarantee period ends. The adjustment could be positive or negative. Carefully review the fee schedule before you sign any type of annuity application.

Before buying a deferred annuity, evaluate how it fits into your financial situation. For instance, deferred annuities aren't designed for quick cash access—keep those surrender charges and tax penalties in mind.

You'll also want to choose an annuity that's suited to your retirement strategy and risk tolerance. For example, variable annuities can provide stronger growth potential than fixed annuities, but they also can lose value in a downward market.

When you purchase an annuity, you're depending on the insurance company to provide the payout. While state or federal agencies may protect your premiums, you're ultimately putting your faith in the insurer to make good on their promise. If you decide to buy an annuity, be sure to select one with a solid reputation and strong financial ratings.

If you're looking for a way to plan for retirement income, a deferred annuity may be the right solution. As long as you won't need to tap into your funds for several years, you gain the potential to grow wealth and receive guaranteed annuity payouts when you retire.

But with those pros come other factors to consider, including some tax consequences. A Thrivent financial advisor can help you decide if deferred annuities are a sensible choice for your personalized financial plan.