What Is A Tax-Deferred Annuity? (Deferred Annuity Definition)

Where do you see yourself in retirement? Are you poolside, sipping a margarita in your resort-style retirement community?

Or are you sifting through a stacks of bills, wondering how you’ll pay them?

Most people hope for the former. But it takes planning to be able to afford your ideal retirement lifestyle.

Deferred annuities are a powerful way to plan for financial security well ahead of retirement. They are products issued by insurance companies that can provide stable, guaranteed lifetime income.

Purchasing a deferred annuity now and letting it grow for years can help you secure the retirement life you envision for yourself.

In this article, we cover exactly how deferred annuities work. We discuss the different types, tax implications, and benefits and drawbacks.

What Is a Deferred Annuity?

Annuities are insurance contracts. You purchase annuities from a life insurance company.

They work almost like a personal pension: You pay the insurance company now, and in return, the insurance company pays you a steady income stream later (typically, in retirement).

Deferred annuities are one of the two main types of annuities. The other annuity type is an immediate annuity (also known as an “income annuity”).

In an immediate annuity, you pay the insurance company now, and the company begins to pay you your periodic payments almost immediately—usually within a year of purchase. You typically purchase an immediate annuity when you’re in retirement or close to it. If you'd like to learn how these types of annuities are treated, checkout our guide to annuity taxation.

Deferred annuities don’t pay you right away. Instead, you purchase them before retirement—sometimes decades before. Your money builds and builds for years.

Then, when you’re ready to receive payouts, you can annuitize your deferred annuity. The process of annuitization starts the cash flow, and you begin to receive your stream of income.

How Do Deferred Annuities Work?

A deferred annuity works in two phases: an accumulation phase and a payout phase.

In the accumulation phase, you fund your annuity. You can pay a single lump sum of money, or you can make payments over a period of time. While your annuity is accumulating, it’s also earning interest.

When you reach retirement age, you can begin the payout phase. You go through the process of annuitization and begin to receive your annuity paid back to you as a steady stream of income.

Typically, you receive payouts as regular periodic payments, although some individuals opt for lump-sum payments instead.

Deferred Annuities vs. Tax-Deferred Annuities (TDAs)

Before we go any further, let's clear up any confusion. This article is talking about the insurance product known as deferred annuities. They are often called “tax-deferred annuities” because they allow the owner to defer paying taxes on gains. But the word deferred in the name refers to when you will start taking payments (in the future as opposed to immediately) and not that you can defer paying taxes.

However, another category of retirement savings accounts is also called “tax-deferred annuities” (TDAs). These TDAs go by several different names, including “voluntary savings plan,” “supplemental plan,” “tax-sheltered annuity (TSA),” and even “403b plan.”

This 403b plan allows you to contribute a portion of your salary into an account, where it earns interest and grows tax-deferred. Often, they are employer-sponsored, and your employer matches your contributions. Though they have some similarities to regular deferred annuities, these plans are not the subject of this article.

Types of Deferred Annuities

The category of deferred annuities can be further broken down into types based on how their interest accrues.

The most common types are fixed annuities, variable annuities, and fixed-indexed annuities.

Fixed Annuities

Fixed annuities mean interest accrues at a fixed rate. They offer a guaranteed minimum rate of return on the principal for the entirety of the term you select. That means that your fixed annuity interest rates will never drop below that minimum. Y

our insurer may give a higher interest rate, but it will never be lower.

Fixed deferred annuity calculation example

Imagine you purchased a fixed annuity for $100,000 with a 5-year term. The guaranteed fixed interest rate over that term was 3%.

Over the 5-year term, your fixed annuity would earn more than $15,000.

Variable Annuities

In a variable annuity, the interest rate you receive is variable. When you set up the annuity, you choose sub-accounts for your funds. These sub-accounts are invested into assets like mutual funds, stocks, and bonds. The performance of the subaccounts determines the rate of return on your annuity.

If your investments perform well, your earnings can be quite high. But if your investments perform poorly, you could earn nothing—or even lose money.

Variable annuities allow you to take advantage of a growing economy, but they also carry significant risk. Always check your contract to understand exactly how your interest rate will be calculated.

If you’re unsure about your variable annuity contract, speak with a financial advisor before signing on the dotted line.

Fixed-Indexed Annuities

Fixed-indexed annuities land somewhere between fixed and variable annuities. Like a variable annuity, the interest rate for a fixed-indexed annuity depends on market performance.

You choose a market index to follow, like the S&P 500, and your interest rate varies with that index’s performance. If the index performs well, your rate of return increases.

If it performs poorly, your rate of return decreases. Fixed-indexed annuities are also similar to fixed annuities because they offer a fixed minimum interest rate—often 0%. That guarantees you won’t lose everything if your index tanks, although you may not have any gains either.

Again, always check your contract to see exactly how your interest rate will be calculated. And if you’re unsure, speak to a financial professional who can help guide you toward your personal finance goals.

Single-Premium Deferred Annuity vs. Flexible-Premium Deferred Annuity

Deferred annuities also differ in how you fund them. You fund a single-premium deferred annuity with a single, lump-sum payment. With a flexible premium deferred annuity, you fund the annuity through a series of payments, usually over time.

These different options each allow you to customize your annuity so it is the ideal fit for your financial circumstances.

How Do Taxes Work?

Deferred annuities are often called “tax-deferred” annuities because you don’t pay taxes on your funds during the accumulation phase.

Instead, you pay taxes in the payout phase when you begin receiving your annuity payments.

Notice that “tax-deferred” is not the same as “tax-free”. You will pay ordinary income taxes on the gains in your annuity when you start to receive the money.

This tax deferral provides some significant advantages.

First, it means that your money earns more interest. Keeping more of your money in your annuity, rather than giving it to the IRS right away, allows it to compound faster. That compounding contributes to your earnings.

Second, you’ll likely pay less in taxes. Annuities are taxed as regular income. Deferring your taxes until retirement usually means deferring your taxes until you are in a lower tax-bracket. That means you will probably pay a lower amount in taxes than you would if you paid taxes when you were working.

Remember that your taxes may be applicable to your entire withdrawal or just the earnings depending on whether you have a qualified or non-qualified annuity.

Is a Deferred Annuity Right for You?

Deferred tax annuities are fantastic retirement planning tools. They can help you feel secure knowing that you’ll have a steady retirement income throughout your golden years.

But they may not be for everyone.

Here are some of the advantages and disadvantages of deferred annuities.

Advantages of Deferred Annuities

• They provide a steady source of income payments in retirement if you choose to annuitize.
• They allow you to compound earnings over time.
• You will usually pay taxes on your annuity earnings when your income tax rate is relatively low.
• They let you grow your retirement funds over time.
• Most deferred annuities have no contribution limits, so you can make your investment as large as you like (unlike other tax-deferred products, such as IRAs and 401(k)s).
• They’re usually customizable, so you can choose your preferred payment option, add death benefits, and so on.
• Fixed annuities provide a guaranteed rate of return on your money, and it’s higher than the rates for most savings accounts and CDs.

Disadvantages of Deferred Annuities

• The money in your annuity may not be very accessible to you while it’s growing.
• There can be fees (surrender charges and tax penalties) for removing funds from your annuity early.
• Variable annuities are risky and you could lose money (this doesn’t apply to fixed annuities).

Who Is a Deferred Annuity Best For?

Deferred annuities are best for individuals planning for retirement in advance; those who don’t need their annuity income payments to start until several years down the road.

If you’re looking for a product that pays you back right away, an immediate annuity may better fit your personal finance goals. Compare all the annuity plans you are considering in order to find the best fit for you.

A Deferred Annuity Could Make All the Difference to Your Retirement Lifestyle

Deferred annuity contracts could make all the difference to your life in retirement. If you're planning ahead for your retirement, consider a fixed deferred annuity. They are a powerful way to supplement your social security check and help you afford the retirement lifestyle you want for yourself.

Think that an annuity could be right for you? Get in touch with our licensed representatives. They can help you develop your plan and understand your options.