A deferred annuity is a type of annuity contract that delays payments of income, installments, or a lump sum until the investor elects to receive them. This type of annuity has two main phases: the accumulation phase and the annuitization phase.
- Accumulation Phase: During this phase, the investor contributes money to the annuity, which accumulates on a tax-deferred basis. In other words, the money within the annuity grows and compounds over time without being subject to taxes until withdrawal.
- Annuitization Phase: This phase begins when the investor decides to start receiving scheduled payments from the annuity. At this point, the deferred annuity can be converted into an immediate annuity to start receiving payments. The income received during this phase is typically subject to income tax.
Deferred annuities can be either fixed or variable:
- A fixed deferred annuity earns a fixed rate of interest during the accumulation phase and pays a guaranteed income during the annuitization phase.
- A variable deferred annuity allows the owner to invest in a selection of sub-accounts (similar to mutual funds). The rate of return during the accumulation phase and the amount of income during the annuitization phase can fluctuate based on the performance of these investments.
Deferred annuities are commonly used as a retirement planning tool, allowing individuals to accumulate savings on a tax-deferred basis and then receive a steady stream of income in retirement. However, they can be complex and may come with various fees and charges, so it’s important for potential investors to fully understand these products and consider whether they align with their investment goals and risk tolerance.
Example of a Deferred Annuity
Let’s say John, who is currently 45 years old, is planning for his retirement. He decides to invest in a deferred annuity to help provide a steady income stream after he retires. He plans to retire at 65, giving him 20 years during which he can invest in the annuity.
John decides to contribute $10,000 per year to a fixed deferred annuity, which offers a guaranteed annual interest rate of 3%. This is the accumulation phase.
Over the 20 year period, John’s investment grows, with interest compounded annually on a tax-deferred basis. At the end of the accumulation phase, when John turns 65, his annuity has grown to approximately $367,000 due to the power of compound interest.
Upon retirement, John enters the annuitization phase. He decides to receive annual payments for the rest of his life. The amount of these payments is determined based on several factors, including the total value of the annuity, John’s life expectancy, and the terms of the annuity contract. Assuming these factors result in an annual payment of $20,000, John can look forward to this steady income for his retirement years.
It’s important to note that the $20,000 John receives annually will be subject to income tax since the contributions to the annuity were tax-deferred, meaning they were made with pre-tax dollars.
This is a simplified example, and actual annuity contracts can be much more complex. Factors such as fees, surrender charges for early withdrawal, and the financial strength of the insurance company offering the annuity can all affect the performance and safety of the investment. Therefore, it’s always a good idea to seek professional financial advice when considering an annuity.