The Pros and Cons of Tax-Deferred Annuities

Tax-deferred annuities are popular for a good reason—they offer massive benefits to retirees. Annuities can help you grow your retirement savings. They're tax-deferred, so you only pay taxes when you withdraw funds. Plus, an annuity can provide you with guaranteed lifetime income.

But tax-deferred annuities have some drawbacks, too. They are fairly illiquid. That means once you put your money into one, you can incur penalties if you withdraw it before the end of your surrender charge period. Also, depending on the company you buy from and the type of annuity, you may have high fees. And unless you’re looking for a variable annuity, they're not ideal for anyone looking for a risky investment option with very high growth potential.

This article explains everything you need to know about the advantages and disadvantages of tax-deferred annuities. Keep reading to find out if this benefit might mean an annuity is right for you.

What Is a Tax-Deferred Annuity?

All annuities are tax deferred, meaning your interest earns interest until you make a withdrawal.

Annuities work like this: You buy an annuity from an insurance company and fund it by paying premiums. Premiums are just the deposits you use to fund your annuity. That money is still yours—it’s just safely tucked away in your annuity.

Assuming you’ve purchased a deferred annuity, once you fund it, the accumulation phase starts. This is when your principal earns interest and grows. When you decide you’re ready to receive income payments, you can annuitize your annuity and begin the payout phase.

During the payout phase, you can receive a steady stream of guaranteed income. This phase can last for a period of time or for the remainder of your life (or your life and your spouse’s life if you select joint income).

Tax-deferred annuities are "deferred" because you do not pay taxes on the gains until you withdraw the money. Since most people are in a lower tax bracket during retirement, this gives you both the benefit of earning interest on the money you would have otherwise paid in taxes and means you pay less in taxes overall on the same amount of money. This is just one of the biggest tax advantages of annuities.

Are There Different Types of Tax-Deferred Annuities?

The IRS has given all annuities tax deferral benefits, but there are many different types of annuities to choose from.

First, you can consider single premium or flexible premium annuities.

You can buy an annuity with a single, lump-sum payment, known as a “single premium annuity.” You can also choose an annuity that you fund over a period of time. This is a “flexible premium annuity.”

You can also consider annuities based on how their interest rate is calculated, such as fixed annuities, variable annuities, or fixed indexed annuities. A fixed annuity is the safest kind of annuity. It’s low-risk because it has a guaranteed fixed minimum interest rate. That means you know exactly how much your annuity will earn over time. Variable and fixed indexed annuities are both riskier annuity types.

A fixed annuity is the safest kind of annuity. It’s low-risk because it has a guaranteed fixed minimum interest rate. That means you know exactly how much your annuity will earn over time. Variable and fixed indexed annuities are both riskier annuity types.

Fixed indexed annuities are linked to the performance of an index. The growth of that index determines the crediting rate applied to the annuity. With a fixed indexed annuity, you still have a guaranteed minimum crediting rate, usually 0%.

With a variable annuity, you choose from available sub-accounts to invest your money into. The performance of these accounts determines the account value of your annuity. You can lose money with a variable annuity, just like you could if you invested directly in the stock market.

For the rest of this article, we will only discuss fixed annuities. These are the safest annuities and the kind of annuities we sell at Canvas Annuity.

Tax-Deferred Annuity Advantages

So, what are the benefits of tax-deferred annuities? There are a lot. Here are some of the biggest advantages of having a deferred annuity in your retirement plan.

Guaranteed Income in Regular Payments

An annuity contract guarantees that you'll receive retirement income (as long as you follow the contract conditions). This is powerful because it makes retirement planning more predictable.

An annuity is the only financial product that offers guaranteed income. Other retirement instruments do not provide this advantage. That's one of the biggest differences between annuities and 401(k)s or IRAs. 

Tax-Deferred Contribution Growth

The other main benefit of annuities is that your contributions grow tax-deferred.

With most investment options (like stocks, certificates of deposit (CDs), bonds, and mutual funds), you have to pay taxes on your earnings in the year you earn them. But with annuities, you don't pay taxes on earnings until the year you receive them.

Note that annuities are not tax-free. You will still have to pay income tax on your annuity income. Also, note that annuity income is taxed at the ordinary income tax rate. This taxation is different from other investment asset earnings. Investment earnings are typically taxed as capital gains.

Finally, be aware that tax rules differ depending on whether an annuity is qualified or non-qualified. For more details on paying taxes on annuities, check out our article on annuity taxation.

Death Benefits May be Available

Most annuities offer death benefits. Death benefits allow you to name a beneficiary to inherit your annuity after your death.

For example, imagine you purchased an annuity that had a value of $500,000. Now imagine it paid you $250,000 in income during your retirement. When you die, there would be $250,000 left. The beneficiary you name would inherit that amount.

Many annuity contracts have death benefits built-in. However, when this is not the case, you can usually purchase them as an optional add-on or "rider."

Death benefits make annuities a powerful legacy planning tool. See our article on annuity death benefits for more details.

No Medical Screening or Health Qualification Required

Annuities also have an advantage over life insurance as a legacy planning tool.

Life insurance pays your beneficiaries a sum of money if you die. For most life insurance policies, you must medically qualify. Having a health condition may disqualify you from many life insurance products.

Annuities do not require medical screening. You can apply for them regardless of your health condition. That's good news for people with health issues who want to leave a legacy for their families.

Guaranteed Rates of Return with Fixed Annuities

One reason fixed deferred annuities are great investments is they have a guaranteed minimum rate of return. That means you can be sure that your money will grow over time. Fixed annuity interest rates are quite high, too. They’re usually much higher than other low-risk investment options like CDs.

For example, Canvas Annuity currently offers a 7-year Future Fund annuity with a guaranteed crediting rate of 3.25%. This is one of the best annuity rates in the industry.

No Contribution Limits

Some retirement accounts, like IRAs and 401(k)s, have contribution limits. Those limits can be an obstacle for building up your nest egg to your desired amount.

In contrast, most annuities don't have contribution limits. That means you can fund them with as much money as you want.

Tax-Deferred Annuity Disadvantages

While tax-deferred annuities have many important benefits, they are not for everyone. Here are some of the drawbacks to consider before buying a tax-deferred annuity.

Illiquidity

Tax-deferred annuities are long-term investments. The idea is that you set aside retirement savings, and it grows over time. Then you can decide when you're ready to receive a steady stream of income.

You can take money out of your annuity before retirement, but you may face early withdrawal penalties from both the insurance company and the IRS.

Most annuity companies levy a surrender charge if you withdraw from an annuity during the surrender charge period. (Your annuity contract tells you when your surrender charge period is.) Always read your contract carefully. It’ll explain all the expenses associated with withdrawing from your annuity.

Also, note that the IRS levies a 10% tax penalty against early withdrawals from retirement accounts before age 59½. That tax penalty applies to most early withdrawals from annuities.

In short, annuities are best if you are pretty sure you will not need to access your money early. If you make early withdrawals, it might cost you.

Fees

Some annuity companies charge hefty administrative fees. These can make an annuity very expensive. Variable annuities tend to have the highest fees. But some companies charge fees on fixed annuities, too.

At Canvas, we offer straightforward annuities for real people. That's why we have zero commissions, account charges, or fees.

Fixed Annuities Have Limited Growth Potential

Fixed annuities can offer steady, low-risk growth. If you're looking to grow your money safely over the long term, fixed annuities are a great choice.

The disadvantage is that they don't offer the high growth potential that higher-risk investment options can offer. If you're an investor who wants a high-risk, high-reward investment option, annuities may not be the best fit. (But annuities can be an excellent way to balance high-risk investments in a diversified portfolio.)

How To Tell If an Annuity Is Right for You

Americans' top retirement worry is that they will run out of savings. Annuities directly address that concern by offering lifetime income. They help you feel secure knowing that you'll have some money coming in for the rest of your life.

Annuities also have several other benefits. They provide significant tax advantages and death benefits. Plus, fixed annuities can offer steady, low-risk growth at a good rate. If those advantages appeal to you, consider buying an annuity.

But annuities are not for everyone. If you want to easily access your cash at any time, they may not be the best choice. They're meant for the long term and are not suitable for short-term investing. Also, you may not be interested in them if you're a more high-risk, aggressive investor. (Unless you're looking to add safer options to diversify your portfolio.)

Annuities are all about fit. They can be powerful products, but not necessarily for everyone. It's a good idea to consider whether they're the right fit for your financial situation and retirement needs.

If you're not sure, consider consulting with a financial advisor. They can work with you to help you understand which products may best reach your financial goals.

Still uncertain about the pros and cons of annuities? Just reach out—our licensed representatives can help! They are happy to explain the advantages and disadvantages of annuities. And they can help you understand if annuities can meet your needs. If you’re ready to level up your retirement plan, apply for an annuity today!