If you make annual contributions to a retirement plan, or you’re about to start setting money aside for your golden years, this article’s for you. Annuities, in general, get mixed reviews because they’re so often misunderstood.
Jump ahead to these sections:
- Definition of a Deferred Annuity
- Different Types of Deferred Annuities
- Pros and Cons of Deferred Annuities
- Alternatives to Deferred Annuities
It can get a bit complex when you compare all of the different types of annuities, but this article will take some of the mystery out of annuities for you by concentrating on only one kind of annuity─the deferred annuity.
This article will answer some of your questions about annuities: what a deferred annuity is, how it works, its tax benefits, alternatives to deferred annuities, and more.
Definition of a Deferred Annuity
Before we dive into deferred annuities, let’s go back to square one for a minute and define what an annuity is. Here’s a definition that explains what an annuity is in one sentence: “An annuity is a long-term investment that is issued by an insurance company and is designed to help protect you from the risk of outliving your income.” (Nationwide)
In other words, the insurance company says, “Give us your money, we’ll guarantee that it earns interest, and we’ll pay it out to you for as long as you live.”
When you purchase an annuity, you have to let the insurance company know when you’d like those payments to start. You can opt to have payments start immediately, or you can choose for them to start at some later date.
A deferred annuity is the type of annuity where you start getting payments from your insurance company at a later date, not immediately.
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Different Types of Deferred Annuities
While you’re completing your paperwork for an annuity, the insurance company will ask you, “How are you going to pay for this?”
Here are your two choices:
- Single premium deferred annuity. This type of deferred annuity is where you pay for the annuity by giving the insurance company one lump sum of cash.
- Flexible premium deferred annuities. These deferred annuities allow you to put money into your annuity by making a series of payments to the insurance company. You can make these premium payments monthly, quarterly, semi-annually, or annually. You’ll schedule your payments when you complete your paperwork, but it’s essential to know that you can change that amount (increase or decrease) as you see fit.
You might be wondering if there’s an advantage to one type of deferred annuity over the other. Here are some things to consider:
Some people prefer the principal protection of the single premium deferred annuity. With this type, your money is protected against market risk. On the other hand, by making a large lump-sum payment to the insurance company, you may lack funds for other investments that could be more profitable.
Some people prefer the flexible premium deferred annuity because they have less capital tied up and more time to pay for their annuity. And with a single premium deferred annuity, it can be very costly to get your money out if you need it. You can still have penalties for withdrawing money from a flexible premium annuity, but they’re typically much lower.
Pros and Cons of Deferred Annuities
Like any financial product, deferred annuities have some benefits and risks. Let’s look at each.
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Pros of deferred annuities
Here are the main benefits of deferred annuities:
Tax deferral: As your money inside the annuity grows from the interest credited by the insurance company, you won’t be taxed on that growth every year, much as you’re not taxed on the growth of an IRA or 401(k). You’ll pay taxes on that growth only when you start to receive income from the insurance company because it’s then taxed as ordinary income.
Guarantee against loss: Not all but many deferred annuity contracts have a built-in guarantee against a loss of principal or a guaranteed rate of return.
Lifetime benefits: Once you start receiving payments, the insurance company guarantees lifetime payments for you or your spouse.
Death benefits: This feature ensures that any surviving heirs will receive any remaining funds in the annuity if you pass away before the end of the annuity contract.
No contribution limits: Unlike 401(k)s and IRAs, there’s no limit placed by the IRS on the amount you can contribute to a deferred annuity.
Cons of deferred annuities
Now here are the potential negatives of deferred annuities:
Lack of liquidity: if you want to withdraw any money from your annuity contract during the first few years, you’ll be paying a “surrender charge” to get it. And if you’re under 59½ years old, you’ll also be paying a penalty to the IRS for early withdrawal.
High tax rates on earnings: One of the pros listed above, tax deferral, also carries with it a con. When you take money out of your annuity, it’s taxed as ordinary income. Depending on your tax bracket at the time of withdrawal, you may be paying a higher tax rate than you would have if you were paying capital gains taxes, which are associated with stocks, mutual funds, and exchange-traded funds.
Expenses: Every financial product has some expense costs, even if they’re advertised as “no-load.” Administrative fees, funding expenses, charges for riders, and commissions can eat away at your gains; so know you’re expenses up front and shop around for an annuity with reasonable expenses from a name-brand insurance company.
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Alternatives to Deferred Annuities
Beware of the insurance agent who only tries to sell you an annuity without comparing it to some other options you have when it comes to building up your account balance over time. You do have alternatives, which include:
Certificates of deposit: Also known as CDs, these pay meager interest rates, and your money is tied up for the length of the contract unless you want to pay some pretty hefty early withdrawal penalties. The interest earned on a CD is taxable, not the return of your investment when the contract matures.
IRAs: These are more popular than annuities for one main reason─tax advantages. With a traditional IRA, every dollar you contribute is tax-deductible, up to the IRS’s contribution amount limit, which is adjusted from time to time.
Your contributions to a Roth IRA aren’t tax-deductible, but you don’t pay any taxes when you withdraw money from a Roth IRA. Like the traditional IRA, the Roth IRA has annual contribution limits, and all IRAs are subject to an early withdrawal penalty if you take your money before you turn 59½.
When comparing IRAs to deferred annuities, it’s important to know that you can outlive the money in your IRA, but you can’t outlive the money in your tax-deferred annuity.
Life insurance: Many life insurance agents believe that life insurance is the solution to every financial need, including saving for retirement or just putting money away. There are indeed tax advantages when you’re accumulating money inside of a life insurance contract.
Withdrawals from the policy's cash value aren’t taxed, though the withdrawal will take away from the amount of money you’ll have compounding in the policy.
Loans from the cash value aren’t taxed, but any outstanding loan amount will be deducted from the death benefit payable to your beneficiaries when you pass away.
When you die, the death benefit paid to your beneficiaries is not taxable.
The downside of buying a life insurance policy to build wealth is that a portion of every dollar you pay the insurance company will cover the cost of the life insurance, whether you need it or not. The money you’re spending on the life insurance component could have been invested elsewhere, with many of those investments paying a higher rate of return than a whole life insurance policy.
Do Deferred Annuities Deserve Their Bad Reputation?
We’ll let you be the judge of that, but you can see that there are some pros to deferred annuities. Remember, annuities are not technically an “investment.” Instead, they’re a contract with an insurance company to pay you income for life.
When buying any financial product, it’s wise to get quotes and information from more than one agent or representative and more than one company.
Fees, commissions, and rates of return will vary from company to company, so do your homework. And be sure to check the financial ratings of the insurance company. You’re going to be dependent on them for income for the rest of your life, so confirm that they have the financial strength to be around as long as you are.