You’ve probably heard that annuities are a great way to provide for your future. You may also know that there are different types of annuities: every annuity is either variable or fixed, and either immediate or deferred. This brief guide will tell you everything you need to know about deferred annuities (also sometimes called deferred payment annuities, or delayed annuities), so that you can decide whether this type of annuity is right for you.
How Deferred Annuities Work
Deferred annuities are contracts sold by life insurance companies, which invest your money and then pay it back to you, plus interest, over a specified period of time. As their name implies, deferred annuities (unlike immediate annuities) defer, or delay, these payments until you elect to receive them. Thus, they have two distinct phases: the savings (or accumulation) phase, and the income (or annuitization) phase. The accumulation phase begins when you invest money into the account. You can do this over time, via monthly contributions, or all at once. The annuitization phase begins, often years later, when you start to receive payments.
The Advantage of Tax Deferral
One of the main advantages of deferred annuities is that, like all annuities (but unlike other types of savings accounts, such as mutual funds or Certificate of Deposit accounts), they offer tax-deferred growth. What this means is that when the annuitization phase begins, or when you begin making withdrawals from your annuity, your earnings are taxed at your regular income tax rate, but the original amount that you put into the annuity is never taxed.
To demonstrate the benefits of tax deferral, let’s take a look at the difference between investing in deferred annuities and CDs in two different scenarios:
Scenario 1: Tax Rate Stays the Same
John is 55 years old. For the next 10 years he puts $100,000 into a CD and $100,000 into a deferred annuity that grows tax deferred. They both grow his money at the same yearly rate of 2.65%. John’s current tax rate is 38%, and we assume it stays at 38% even after 10 years.
During these ten years, John’s tax rate remains constant at 38%. With a CD, over the course of those 10 years, John’s value would increase to about $129,000, with him paying $11,360 in taxes over the course of his term. This would bring the net value of his CD to $118,534 at the end of the 10 years. Because John’s tax rate remained constant, the value of his deferred annuity would end up the same ($118,534) as his CD, with John paying the full $11,360 at the end of his term, rather than over the course of the full ten years. In this scenario, both the CD and the annuity have the same value; the taxes are just paid differently.
Scenario 2: Tax Rate Drops
Scenario 2 is the same as scenario 1, except that John’s tax rate drops to 15% in year 10 when he retires.
In this scenario, the deferred annuity would generate $6,000 more than the CD. That’s because with the CD John would have been paying a steady 38% in years 1-9, and 15% in year 10, totaling $10,588 in taxes over time. With his deferred annuity, he only pays taxes in year ten, meaning he will be taxed on his total $100,000 annuity at the 15% rate, resulting in a tax bill of $4,484. Clearly, an annuity was useful here as it saved him $6,000.
As you can see from the above scenarios, deferred annuities are an excellent option if you can see your retirement on the horizon, because you won’t have to pay taxes on the money in your annuity until the end of its term. If you plan it so that the term ends after you retire, you will only be taxed at the lower, post-retirement rate.
Pros and Cons
While tax deferral is an obvious advantage, deferred annuities also come with a few disadvantages. One is that the insurance brokers who sell annuities charge a commission fee for their services, which can be up to 10% or so.
Another disadvantage is that deferred annuities are illiquid, which means that if you take money out of them within the first few years after you buy them (called the surrender period), you will have to pay a fee called a surrender charge.
All in all, however, if you are prepared to leave the money that you invest in them alone for a while, deferred annuities can be a great way to grow your money over a long period of time while ensuring that you’ll be provided for in your retirement years. Aside from retirement, another common use of deferred annuities is to put money aside for children who will begin receiving payments upon reaching a specified age.
Generally considered to be a safe and reliable type of investment, deferred annuities are a smart way to plan for the future.