Generating an income for retirement is a big financial challenge people are facing. A deferred annuity (延期年金) is an insurance contract that converts a lump sum into a future income stream you cannot outlive, with payments starting on the date you choose.
This financial product offers long-term growth and retirement income. It consists of two phases: payout and accumulation.
How does a deferred annuity work?
A deferred annuity goes through two phases:
- accumulation phase
- payout phase
Accumulation phase
The annuity value grows during the accumulation phase. How it grows depends on the deferred annuity type you select. Earnings grow tax-deferred during this phase. This means you do not pay taxes on earnings until the funds are withdrawn.
Payout phase
You choose how to receive the money at the end of the accumulation phase. You choose how to receive the money, such as:
- Take a lump sum
- Annuitize the contract to receive regular income payments
You can avoid the 10% early withdrawal penalty by taking withdrawals at the age of 59½ or older. Withdrawals are subject to ordinary income tax. The withdrawals are taxed as ordinary income. You owe an additional 10% federal tax penalty if you take money out before age 59½.
Types of deferred annuities
Each type of deferred annuity works differently.
Fixed annuities
Growth is based on the interest rates in your annuity contract with a fixed deferred annuity. The contract outlines the following:
- Guaranteed interest rate
- How future interest rates are determined
- How long that rate applies
The fixed annuity offers predictable growth according to the contract terms. The credited rate does not increase more than what is stated in the contract if overall interest rates or inflation rise.
Variable annuities
Growth depends on how you allocate the money among the investment options called subaccounts with a variable annuity. The options offer higher growth potential than the fixed annuity. However, you must learn about the following:
- Growth is not guaranteed
- You could lose principal based on the market performance
- The value of your contract fluctuates
Past performance will not guarantee future results.
Fixed indexed annuities
A fixed indexed annuity credits interest based on the financial index performance. Your money is not invested in the stock market directly. Your return will not match the index precisely. The features of fixed indexed annuities include:
- Protection from losses because of poor index performance
- Limits on the amount of index gain you receive
For example:
A contract includes an 80% participation rate. Your annuity is credited with 4% if the index increases by 5%.
Indexed annuities carry more risk compared to fixed annuities. But it is less risky than variable annuities. The fixed annuity has a minimum guaranteed rate of interest. The downside risk from the index is limited by the guarantee with an index annuity. A variable annuity loses value from the variable options, though a fixed option with a guaranteed interest rate is present.
Preparing for retirement
You may consider a deferred annuity if you have reached the contribution limits. Retirement accounts have yearly contribution limits set by the IRS. The annuities do not have similar IRS contribution limits. It allows you to put in additional money, which is more than the qualified plan limits.
Any earnings grow tax-deferred until withdrawal. This increases the funds available to you for retirement.
FAQs
How can you compare between an immediate annuity and a deferred annuity?
A deferred annuity delays the income payments. You will receive it until a future date. The time allows it to grow during the accumulation phase. An immediate annuity starts income payments after purchase, within 12 months. The primary difference is when the income begins.
What are the fees associated with deferred annuities?
The fees depend on the type of deferred annuity. Variable annuities include:
Fixed and indexed annuities have fewer visible fees. However, it includes costs built from the contract structure.
