What is a deferred annuity & how does it work?

The bottom line:

Deferred annuities are designed to build income for your retirement through tax-deferred growth potential.

Deferred annuities can be purchased in a lump sum or through individual payments (contribution limits apply).

Deferred annuities are available in fixed and variable to match your risk tolerance.

A deferred annuity is commonly used to generate a steady stream of income in retirement. Funded by a large, one-time payment or in smaller amounts over months or years, a deferred annuity provides you with flexibility and an opportunity for growth. Payments from your deferred annuity can begin one year after you’ve opened it or later.

Annuities are designed to build income for your retirement through tax deferred growth potential. The interest earned in a deferred annuity is not taxed until you withdraw it.

As long as your money stays in the annuity, you don't owe taxes on your gains. You only owe taxes when you start collecting income. It can help you grow your savings more quickly than if you use a regular brokerage account, whose earnings you must pay taxes on yearly.

Since deferred annuities aren’t returned to you in the form of steady retirement income for some time, they can grow during the accumulation phase. But that’s just the beginning. There are many other benefits to purchasing a deferred annuity, including:

With a deferred annuity, you build your savings today for a retirement income tomorrow to supplement your pension or Social Security. It can provide a consistent income flow to help cover essential expenses like groceries or utilities during retirement.

With a range of deferred annuity types available, you can choose an investment approach that best aligns with your goals and risk tolerance.

Deferred annuities allow you to defer taxes until you receive payments.

Additional features, known as riders, allow you to purchase extra benefits with your contract.

The disadvantages of deferred annuities are that they may not be liquid, early withdrawal taxes may apply, the fees may be high and the structure can be complex.

Once you sign up for a deferred annuity, you may not have immediate access to all of your money if you need it for emergencies. And it can be expensive to withdraw your principal investment earlier than planned.

As part of deferred annuities' tax benefits, the IRS wants you to keep your money in these accounts until you retire. If you withdraw a large sum or cancel your contract before you turn 59½, you could owe a 10% early withdrawal penalty on top of income taxes on your gains.

A deferred annuity could charge high fees in exchange for income and investment guarantees. Make sure you understand the costs of an annuity before you commit to the contract.

Contracts for deferred annuities can be complex surrounding guarantees, fees and terms. You should consult with a trusted financial advisor before purchasing a deferred annuity.

While annuities come with several great benefits, they may not have everything you’re looking for. Companies may offer a variety of riders to customize your annuity to fit your needs. There are fees involved with adding riders, so you should always discuss these options with a financial professional before purchasing your contract.

A few of the popular riders available today include:

• Death benefit rider: Gives you the ability to designate death benefits to your heirs.
  
• Lifetime income benefit rider: Guarantees you’ll receive regular income payments for the rest of your life, even if your annuity is fully depleted.
  
• Cost of living (COLA) rider: Based on inflation, it provides increases in your monthly payments.

The types of deferred annuities are single premium deferred annuity (SPDA), flexible premium deferred annuity, fixed deferred annuity, variable annuity and index deferred annuities. These annuities are classified by their terms, returns, and funding.

A single premium deferred annuity (SPDA) is established with a single lump-sum payment with the potential for investment growth during the accumulation phase. Investment growth occurs on a tax-deferred basis until regular payments begin. These annuities can be either fixed or variable.

This type of annuity lets you fund it in multiple installments rather than one large premium payment. When you choose the contract, you make the first payment, then additional payments at your own pace, without a set schedule. Making multiple payments can help you build up a more significant amount over time.

Fixed is the simplest type of deferred annuity to understand. The insurance company gives you a guaranteed fixed interest rate on your investment when you agree to the length of the guarantee period. That interest rate could last anywhere between a year and the entire length of your guarantee period. A multi-year guaranteed annuity, or MYGA,for example, guarantees that fixed interest rate for the entire contract term. But term options are shorter: typically between three and nine years.

Because fixed annuities are based on a guaranteed interest rate and your income is not impacted by market volatility, you will know exactly how much your monthly payments will be—but the contract also won't benefit from a potential upswing in the market, and it may not keep pace with inflation.

Read more: What is a fixed annuity & how does it work?

A variable deferred annuity allows you to invest your money into subaccounts, which over time can help you keep up with or even outpace inflation. However, subaccounts are dependent on market risk and performance and could lose value. For this reason, variable annuities often offer a death benefit or an optional income rider for an additional fee, which can guarantee income to your beneficiaries. A variable annuity can be a great addition to your retirement income plan if you've already maxed out your Roth IRA or 401(k) contributions.

Read more: What is a variable annuity & how does it work?

With an index deferred annuity, returns are based on a market index, such as the S&P 500. An index annuity limits the highest possible gain and highest possible loss, providing some unpredictability (but not as much as a variable annuity).

The terms "deferred" and "immediate" refer to when the actual distribution of your annuity begins. A deferred annuity is funded with a lump sum or payments over time (called an accumulation period). Payout begins on a future date. An immediate annuity starts paying when you deposit a lump sum or in the first 12 months following its purchase.

The 5-year annuity provides the advantage of accumulating funds over time while benefiting from potential interest growth. A 5-year deferred annuity offers a unique opportunity to plan for your future and secure a steady income stream. With a 5-year deferred annuity, individuals make an initial lump-sum payment or series of payments over time, known as premiums. The annuity then enters into a deferred phase, where the funs grow tax-deferred for a period of five years. At the end of the deferral period, there are several options, including receiving regular payouts over a specified period or converting the annuity into a lifetime income stream.

Once you purchase your annuity, there may be hefty fees involved with withdrawing your money early. Early withdrawals (before age 59½), for example, can result in a 10% penalty paid to the IRS on the amount of the gain withdrawn, in addition to your regular income tax. Early withdrawals can carry surrender charges owed to your financial institution, as well. If you purchase a deferred variable annuity, your annuity could lose value based on the performance of your investment options. It's essential to read your contract documents to learn what's true for your deferred annuity contract.

In addition, as with any financial decision, it's essential to get good financial advice to ensure the deferred fixed or variable annuity you choose offers:

• The income payments you want to supplement your Social Security or pension plan
  
• A level of investment risk you're comfortable with to support retirement goals
  
• Additional options/riders for features important to you, such as survivor payments to your spouse or favorite charity

It's also possible to lose money in a deferred annuity if the organization you choose dissolves. Or if it is unable to pay its obligations when you retire. Help reduce this possibility by selecting an organization with a strong rating. Look at reports from A.M. Best, Fitch, Moody's or Standard & Poor's.

If you decide that you want an annuity, the time to buy one is generally when you’re in your late 50s or early 60s and looking forward to retiring in the next decade or so. A deferred annuity can help supply you with additional income to live comfortably in retirement. And since it can be funded in a lump sum or through a series of payments, it may help you build a more significant nest egg and generate income for the rest of your life.

To learn more about how deferred annuities can help you reach your retirement goals, connect with a financial advisor near you.