According to some reports, the global average life expectancy has nearly doubled to more than 70, since the early part of this century. As life expectancies continue to rise, retirees may need to reconsider their financial strategies and account for supplemental regular income streams to support them during the non-working years of their lives. Deferred annuities provide you with a lifetime of income security during your retired years and may be a good choice. Deferred annuities may guard you against outliving your assets, and hence, play a critical role in retirement planning.

Here is all you need to know about deferred annuities:

What are deferred annuities?

A deferred annuity is an insurance contract where you deposit your money with an insurance company, which agrees to pay you a defined or lump-sum amount at a specific date in the future. This is a specific type of contract for long-term savings and works opposite to how an immediate annuity functions, where monthly or yearly payments begin almost immediately. Most retirees invest in annuities to supplement their retirement income, such as Social Security benefits and other retirement account savings.

Annuities became popular among investors during the Great Depression when stock market volatility hampered retirement savings. Further, with the increasingly declining presence and attractiveness of pension plans in the U.S., annuities have become a beneficial option to ensure guaranteed income streams.

How do deferred annuities work?

Deferred annuities are long-term contracts that you enter into with an insurance company. As per the terms, you deposit a sum of money for a specific tenure and in return receive payments after some years, once the initial investment has accrued interest.

Typically, a deferred annuity has two critical components – the investment phase and the income phase. The investment part begins when you start making your contributions and ends when you deposit the last sum. You can also choose to invest a lump sum in the plan. This period is also sometimes called the accumulation or the savings phase. The income phase begins when you first get the payment return from your annuity. This period is often referred to as the payout phase.

You can choose the method of receiving the money from your deferred annuity. You could choose to take the whole money in a lump sum or phase out your total annuity funds in periodic payments across a length of time. You can also opt to annuitize the entire amount to get consistent receipts for your lifetime or your spouse’s life, as per your needs.

What are the different types of deferred annuities?

There are different types of deferred annuities, namely – fixed, indexed, variable, and longevity.

1. Fixed deferred annuity

A fixed deferred annuity imitates the functioning of a cash deposit (CD). These annuities promise a guaranteed and a defined rate of return on the funds in your account. The minimum return you will earn is specified by the insurance company in advance. The payout can be more but is not less than the minimum agreed upon. However, the interest, in this case, is deferred until you make a withdrawal from the annuity contract. Fixed annuities are a preferable option for you if you do not need the interest earnings until the age of 59.5. However, before considering investing in fixed deferred annuities, you should consider other options, such as government bonds and CDs.

2. Variable deferred annuity

In this specific type of annuity, the funds are placed in an investment account, from where they are invested, according to your risk appetite, life stage, and other parameters. The investment choices are limited and essentially include stocks and bonds. Unlike a fixed annuity, the return on indexed annuities varies as per the performance of the underlying assets, which is a portfolio of mutual funds that you chose. The investment in these annuities is tax-deferred until withdrawn. Moreover, these annuities provide rider options like death benefit, future income, etc., which help to extend the coverage in retirement.

3. Indexed deferred annuity

These types of deferred annuities are also known as an equity-indexed annuity. They are a hybrid of fixed and variable deferred annuities. However, they function more like a fixed annuity. Indexed deferred annuities offer you a minimum guaranteed return and also an option to earn better by tying your earnings with a return-based formula. This return formula links your rewards to a particular market index, such as S&P 500. According to the formula, you earn a specific percentage of the growth of the linked index. This amount is also known as the participation rate. For instance, if the S&P index recorded a growth of 10% in 2019, you would get an interest credit of 7% given your participation rate is 70%. Despite the advantages of an indexed deferred annuity, there are some drawbacks to it. Often indexed deferred annuities have a surrender charge if you withdraw your funds during the initial years of the annuity contract. The exact penalty varies as per the insurer.

4. Longevity annuity

This is considered to be one of the most beneficial choices in annuities. According to this contract, your annuity functions like lifelong insurance, which pays you a specific amount for your entire life. This enables you to spend your retirement savings more freely while securing your future. The taxes on the longevity annuity are deferred till the age of 85 years. In case of the death of the holder, the policy is passed on to the authorized beneficiary.

What is the tax treatment on a deferred annuity?

Fixed, indexed, and variable annuities grow on a tax-deferred basis until you withdraw the funds – lump sum or periodic, or start receiving income from the contract. The rate of taxation on annuity withdrawals and income is equivalent to the ordinary income tax rate. In the case of longevity annuity, the funds grow tax-deferred until the age of 85.

That said, if you are below 59.5 when you begin the annuity withdrawals, you will pay a 10% tax penalty on the sum taken out. This penalty is in addition to the income tax levied on ordinary annuity withdrawals.

Should you invest in a deferred annuity?

Like other investment options, deferred annuities also have pros and cons. The suitability of a deferred annuity in your portfolio depends on your retirement priorities, financial goals, risk tolerance, as well as your other sources of retirement income.

However, annuities are generally safe investments because they are solely sold by insurance companies and regulated by strict laws. Moreover, there is no upper cap in the contribution limits, specified by the IRS (Internal Revenue Service) unlike for other retirement accounts like a 401(k) account. On the other hand, returns, surrender charges, and fees involved for annuities may be a drawback as compared to other retirement investment options. That said, the ultimate choice depends on your investment portfolio and other related factors. In many cases, annuities might be an extremely dependable option, given their advantages.

To sum it up

If you want a secure and tension-free retirement with a defined income stream, you may want to invest in annuities and be assured. However, it is may be advisable to consult a professional financial advisor before choosing the type of annuity or making any withdrawals. Informed decisions always lay strong foundations for the future.