Deferred annuities offer individuals who don't have the means to buy an annuity in a lump sum the option of contributing to a plan over time. The person making contributions (the annuitant) can spread his or her contributions out over a number of years if they wish.
How a Deferred Annuity Works
When an annuitant enters into a contract with an insurance company to purchase an annuity, he or she then makes a series of payments over time. The funds are invested on behalf of the annuitant into interest-bearing investment products.
During the accumulation phase, the annuitant may withdraw up to 10 percent of the amount held in the plan annually without being charged a penalty. If the funds are withdrawn before the annuitant reaches the age of 59 1/2, he or she will be required to pay 10 percent to the Internal Revenue Service for income taxes. In addition, the insurance company will charge up to 10 percent of the amount withdrawn for surrender charges and administration fees.
When the annuitant is ready to start receiving money from the plan, the annuity switches to the distribution phase. The payments received are taxed as regular income in the year they are received.
Types of Deferred Annuities
People who are interested in buying a deferred annuity have a number of options to choose from. Before making a decision about which one is right for their needs, they should consider how much risk they are willing to take in their investment choices.
Fixed Deferred Annuity
A person who chooses this type of annuity receives a fixed rate of return on his or her contribution to the annuity. Depending on the insurance company, the annuitant may only be guaranteed a set rate of return for the first 12 months; after that point, the rate of return will rise and fall with changes in market conditions.
This choice may include a death benefit and a minimum level of return for the annuitant. This is a conservative investment choice for people who are at, or close to, retirement age.
Variable Deferred Annuity
Choosing a variable deferred annuity means that the annuitant can choose where his or her money will be invested instead of the insurance company making this decision. Investment options include bond funds, equity mutual funds, and money market accounts. This option is meant for investors who are prepared to take on a higher degree of risk with their investments to potentially get a bigger reward. Some variable deferred annuities offer a minimum guarantee of income for life, as well as a death benefit.
Index Deferred Annuity
An indexed annuity shares some traits with the fixed rate and variable deferred options. During the accumulation phase, the rate of return for the fund is tied to an index of economic performance, such as the Standard & Poor's 500. The goal is to provide a superior level of return on investment as the fund is in its growth.
To protect the investment during times when the market is in a downturn, this type of annuity offers a guaranteed level of income. It also carries a higher level of risk than a fixed rate option, but is less risky than a variable deferred one.
Advantages of Deferred Annuities
The advantage to using deferred annuities to fund retirement is that the annuitant can make a series of small contributions over time. The money grows on a tax-deferred basis and the annuitant can take advantage of compound interest to see his or her investment grow over time.
The earlier the plan is started, the more time the money has to grow before the annuitant is at or close to retirement age. The individual can plan to make small contributions to the deferred annuity for several years and then receive an income for life during the distribution phase of the plan.