Deferred Annuities Explained – What They Are & How They Work


Nobody wants to have to work through their golden years. That’s why you regularly contribute to your IRA, 401(k), and any other tax-advantaged retirement accounts you’re eligible for.

Unfortunately, all retirement accounts have contribution limits. If you’ve maxed out your eligible contributions, consider a deferred annuity. It’s a great option when you have extra cash that you’d like to put toward your retirement nest egg. 

Deferred annuities offer guaranteed income that could last your entire lifetime once you retire. But as with any other retirement investment, there are pros and cons to consider before you dive in. 

What Are Deferred Annuities?

Deferred annuities are insurance products that promise regular monthly payments for a set period of time or one lump sum payment at a predetermined future date. They can increase your retirement income once you’ve reached annual contribution limits on more traditional types of retirement plans. 

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At a Glance

  • Deferred annuities can provide retirement income for a fixed period of time or for your entire life. 
  • They’re designed to increase retirement income provided through more traditional retirement accounts – not to replace them. 
  • Contributions are made on a pre-tax basis, reducing your current tax burden. 
  • You must pay taxes when you begin to collect annuity income. 
  • There are several types of deferred annuities, and terms vary widely. It’s important to read the annuity contract carefully before you hand over your autograph.

Deferred annuities are tax-deferred. That means the money you contribute to the annuity through the accumulation phase is contributed on a pre-tax basis, reducing your tax burden in the year you earned the money. You pay income tax years later, when you start receiving payments from the insurance company. 

Annuities are designed to supplement, not replace, traditional retirement income like Social Security, IRAs, and 401(k) accounts. 

How Deferred Annuities Work

You can think of a deferred annuity as insurance for your retirement. Like other types of insurance, it’s a contract guaranteed by an insurer.

When you sign up for a deferred annuity, you may be asked to make a lump-sum premium payment or a series of monthly premium payments throughout the accumulation period. You pay premiums on a tax-deferred basis, which means you don’t pay income tax on them in the year they’re made. 

A deferred annuity’s payout phase can start as early as age 59½, though you can choose to defer payouts until later — giving the annuity’s balance more time to grow and boosting your monthly payment. The beginning of the payout phase is known as the point of annuitization.

Whenever the payout begins, you’ll receive payments as outlined by the annuity contract. Payment frequency, size, and duration all depend on the type of annuity you purchase, the particulars of your contract, and how long you’ve deferred payments.

Payments you receive in the payout phase are subject to ordinary income taxes. And like most forms of retirement savings, there are penalties if you want to withdraw your money early. Not only will you have to pay ordinary income tax on the money you withdraw, but you may also have to pay surrender fees and a 10% IRS penalty if you’re under 59½ years of age. 

Types of Deferred Annuities

There are multiple different types of deferred annuity contracts on the market today. They’re defined by how long you receive payments and how your annuity funds grow. 

How Long You Receive Payment

Annuity income is designed to give you peace of mind in your golden years. But that steady stream of income may not last your entire life unless you choose a lifetime deferred annuity.

Lifetime Deferred Annuity

The first option, and most appealing for many, is the lifetime deferred annuity. This type of annuity provides regular income payments for the rest of your life once the payout phase kicks in. 

There is no limit to how long the payout on these plans might last. You could become the world’s oldest living person and still cash a check every month. 

Fixed-Period Deferred Annuity

As its name suggests, a fixed-period annuity may not provide lifetime income after retirement because the payout will only take place for a fixed period of time. That means, you only get a limited number of payments. 

The series of payments stops once the fixed period expires. 

How long you receive your payments depends on the options you choose when you purchase the annuity. The typical options are three years, five years, 10 years, 15 years, and 25 years, but your insurance company may have other options to choose from. 

The Lump Sum Option

Most annuities, whether they’re lifetime or fixed-period annuities, come with a lump sum option. That means you can decide to take a large lump sum payment when the payout period begins and forfeit all future monthly payments under the terms of the annuity contract. 

The sum of money you receive depends solely on your contract. In some cases, the lump sum will be equal to the current value of your annuity. In others, it may be lower than the annuity’s current value. Or it might be the net present value of all payments the insurance company expects you to receive over the life of the annuity. Be sure to read your contract’s fine print to understand exactly how much to expect.

How the Annuity Grows

As with any other form of retirement investment, a deferred annuity’s value grows over time. This growth occurs in one of three ways, depending on the contract. 

Variable Deferred Annuity

Variable annuity growth depends on the performance of underlying investment portfolios called sub-accounts. Sub-accounts work like mutual funds: The insurance companies collect investment dollars from a large group of customers, pool those dollars together, and use them to purchase stock market assets. 

As the assets in the annuity’s underlying sub-accounts grow, the value of the annuity itself grows. But stock market assets can also lose value, dragging the sub-accounts’ value with them. 

Fixed Deferred Annuity

A fixed annuity grows at a guaranteed interest rate, much like a Treasury bond or certificate of deposit (CD). The fixed-rate, also commonly referred to as the minimum interest rate, is the amount of interest the annuity funds will earn regardless of the state of the economy or market. 

Returns on fixed annuities are typically the lowest when you compare them to variable or indexed annuities, but they offer a major advantage. There’s limited risk of loss since returns in these annuities aren’t tied to the performance of a bucket of underlying assets or a stock market index. 

Indexed Deferred Annuity

Finally, the rate of return on indexed annuities comes from a stock market index like the S&P 500, Dow Jones Industrial Average, or the Nasdaq Composite index.

Under indexed annuity contracts, insurance companies agree to pay you returns equal to the returns of their underlying index.

For example, if you have an indexed annuity that’s tied to the S&P 500, and the S&P 500 grows, your annuity grows in value. On the other hand, if the S&P 500 falls, so too does your annuity’s value. The risks are similar to variable annuities, but the structure is simpler.

How You Pay the Premium

Another key difference in the different types of annuities is how you pay your premium. Some annuities are paid with one large up-front payment that’s intended to grow over a long period of time, while others are funded through a series of payments. 

Single-Premium Deferred Annuity

When you sign up for a single-premium deferred annuity, you agree to make just one premium payment. In most cases, the single payment is a large one. Most insurance companies require a minimum investment of $10,000 or more to get started. 

The benefit to single-premium deferred annuities is that they are typically long-term and the large up-front payment gives you maximum exposure to potential market growth. On the other hand, many people would have a hard time coming up with $10,000. Even if you can, you forfeit the benefit of dollar-cost averaging with these plans — so if you buy a variable or indexed annuity with a single premium when the market is at an all-time high, your annuity could underperform historic returns for years to come.

Flexible-Premium Deferred Annuity

Flexible-premium annuities are intended to be funded with a series of payments. These are typically monthly payments made over the span of several years. 

These plans are the most common because it’s easier to access the money you need to make smaller monthly payments than it is to pay one large payment. Plus, flexible-premium annuities benefit from dollar-cost averaging. 

Pros & Cons of Deferred Annuities

As with any other type of retirement investment, it’s important to consider the pros and cons of deferred annuities before you sign a contract. Sure, they’re a great option for the right person, but that doesn’t necessarily mean they fit well into your specific retirement plan. 

Pros Cons
Guaranteed retirement income Early withdrawal penalties
Reduce your current tax burden High fees compared to other retirement options
Can produce lifetime income Lack of liquidity
Highly customizable

Pros of Deferred Annuities

There are plenty of reasons to buy into a deferred annuity, and they all center around a more comfortable retirement. Some of the biggest advantages to these savings plans include:

  1. Guaranteed Retirement Income. Deferred annuities guarantee payments when you reach retirement age.  
  2. Reduce Your Tax Burden. Contributions are made on a pre-tax basis, meaning they may reduce your tax burden for the current year. Keep in mind that you will have to pay taxes on your income as you receive your annuity payments.  
  3. Potential Lifetime Income. Few retirement investments offer guaranteed income for life. Sometimes deferred annuities can offer you this high level of financial security.  
  4. Highly Customizable. You can decide how you want to contribute, how you want your money to grow, and how you want to receive payments, making it possible to mold these investments to your unique needs. 

Cons of Deferred Annuities

Deferred annuities are impressive, but no investment is perfect. Some of the biggest disadvantages to these retirement income generators include:

  1. Early Withdrawal Penalties. If you withdraw funds before you’re 59½, you may have to pay surrender charges and a 10% tax penalty on top of your ordinary income tax rate for the money you access.
  2. Higher Fees. Annuities typically have higher fees than traditional retirement accounts like Roth IRAs and 401ks. 
  3. Lack of Liquidity. Annuities aren’t liquid investments. This means that, unlike stocks, exchange-traded funds (ETFs), and mutual funds, you can’t sell your shares and access your money whenever you want. 

Is a Deferred Annuity Right for You?

Deferred annuities are a great way to bolster your retirement income if you meet certain criteria:

  • You’ve Already Hit Traditional Retirement Contribution Limits. IRAs and 401ks typically have lower fees than annuities. It’s usually best to max out your contribution limits on these more traditional retirement plans before you consider investing in an annuity. 
  • You’re Afraid Your Retirement Savings Isn’t Enough. Even if you’ve hit your contribution limits on other retirement investments, annuities may not be your best option. They are a strong option if you’ve hit your limits and you’re afraid that your current nest egg isn’t enough to provide you comfort in your golden years. 
  • You Need to Further Reduce Your Tax Burden. Even if your traditional retirement accounts will provide you with a comfortable retirement, annuities come with tax benefits. You can use them to reduce your taxable income in a big way. 

Deferred Annuity FAQs

Deferred annuities are confusing for first-timers, no doubt. These are some of the most common questions people have about this particular insurance product. 

What’s the Difference Between a Deferred & an Immediate Annuity?

Deferred annuities start making payments at a later date, typically years after you purchase them. You usually fund an annuity with a series of payments spaced over many years. 

Immediate annuities start making payments soon after you purchase them, usually within a year. You purchase an immediate annuity with a large one-time payment rather than a series of payments. 

How Long Can You Defer an Annuity?

You can typically defer your annuity indefinitely and only receive payments when you see fit. This is true in terms of both payment deferral (pushing back when you get paid) and tax deferral (delaying the payment of income tax on your annuity funds).

When Can You Withdraw From a Deferred Annuity?

In most cases, you can withdraw from a deferred annuity as soon as you turn 59½. However, it’s important to read your annuity contract because you may be required to wait longer to access your money in rare cases. 

Can You Surrender a Deferred Annuity?

Surrendering an annuity is the process of cashing your annuity out before maturity. In most cases, you can do this, but the cost of doing so can be high. 

Regardless of your age at the time of surrender, you will be charged surrender fees. These fees typically start at 10% but may fall over time if you hold the annuity for the long term. 

If you’re under 59½, you will also have to pay a 10% tax penalty to the IRS for any withdrawn funds. You must pay the tax penalty in addition to your ordinary income tax rate on the money you receive when you surrender the annuity.  

Final Word

Annuities are the perfect option if you’ve already tapped out your contribution limits on your traditional retirement plans and you’re afraid you might outlive your retirement savings, you need to reduce your tax burden, or both. 

Before you sign up for one, make sure to read the annuity contract. The contract outlines how, how much money, and when, you contribute to the plan. It also explains how your money grows, when you can access it, and all the fees you’re expected to pay. 

Your contract may also give you the option to add riders or make changes to the policy that provide specific benefits, like:

  • Minimum Monthly Payment. This rider provides a guaranteed minimum monthly payment, regardless of the type of annuity you have. So, you could be guaranteed a specific minimum payment even if you choose to buy a variable annuity. 
  • Death Benefit. The death benefit acts as a form of life insurance, typically providing your beneficiaries with a fixed, lump-sum payment of the remaining value of your annuity when you pass. 
  • Living Benefits. Living benefits can provide guaranteed increases to your benefits throughout your golden years as well as lifelong payments for your spouse. 

If you’re not sure if annuities are right for you or need help picking the right one, speak to a financial professional like a financial advisor or certified financial planner (CFP). 

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