What is a deferred annuity?
A deferred annuity is a type of annuity contract that delays income, payments or lump sum payments until the investor chooses to receive them. This type of annuity has two main phases: the savings phase, that is to say when you invest money in the account, and the income phase, that is to say when the plan is converted to an annuity begins to pay the account holder. A deferred annuity can be variable or fixed.
Key points to remember
- A deferred annuity is a contract between an individual and an insurance or financial company that guarantees income at maturity, often until the death of the annuitant.
- Annuities are highly customizable. Payments can be fixed or indexed to a stock market index and may or may not adjust to inflation.
- Early withdrawals from a fixed annuity contract are subject to surrender charges, and are therefore illiquid assets.
Understanding deferred annuities
A deferred annuity is a contract between an individual and a life insurance company in which the funds are exchanged for a promise to provide a competitive interest rate with a minimum interest rate guarantee. The contract also guarantees the main investment. Since annuities are classified as ineligible pension instruments, they benefit from a tax advantage in the form of a tax deferral on earnings. Earnings are taxed as ordinary income at the time of withdrawal or annuity.
There are two types of deferred annuities. As their name suggests, fixed income annuities offer investors fixed income equal to principal and a minimum interest rate. Most life insurance policies are structured like fixed annuities. A variable deferred annuity allows investors to place their money on the stock market through fund-like structures.
The income available to investors depends on the performance of the fund. Variable annuities are regulated by the state insurance services and the SEC. A third type of annuity, known as an equity indexed annuity, is actually a fixed annuity with a fixed income which is linked to the performance of an equity index chosen by the investor.
What are deferred annuities?
How a deferred annuity works
When funds are deposited with a life insurer, they are credited to an accumulation account in the name of the annuity owner. The life insurer then credits the account balance with a fixed interest rate. In most cases, the fixed interest rate is guaranteed for one year to 10 years. At the end of this period, the insurer resets the interest rate, usually for periods of one year.
Most annuity contracts include a minimum rate guarantee which ensures that the interest rate that the account receives never falls below a certain minimum, regardless of the economic climate at the time.
Withdrawals are allowed in most contracts with certain limitations. In a standard contract, the withdrawal provisions allow an annual withdrawal. If a withdrawal exceeds 10% of the account value, the insurer charges redemption fees on the excess. Fees can vary from 7% to 15% on a sliding scale. Each year, redemption fees drop by one percentage point until they reach zero. At this point, the surrender period ends and the annuity owner can withdraw funds without penalty.
Withdrawals are taxed as ordinary income and withdrawals made before age 59 and a half are subject to a 10% penalty. A deferred annuity can be an annuity to provide guaranteed income payments for a specified period of time or for the life of the annuitant.
This type of annuity also includes a death benefit component which ensures that the beneficiaries receive not less than the main investment plus the earnings in the account. The proceeds of the death benefit are taxable to the beneficiary as ordinary income.
Example of a deferred annuity
Jane is in her 30s and is in the upper 30% tax bracket. She wants to ensure that she has a steady stream of income in retirement. She invests in a life insurance policy with an interest rate of 3% per year. It is able to defer taxes on interest received on its premiums. Annuities mature when Jane retires and has another source of income to provide for a comfortable existence after retirement.