What Is Deferred Annuity?
A Deferred Annuity is a financial product that enables individuals to invest and grow their funds over some period, intending to receive regular payments or a lump sum at a later date, typically during retirement. The purpose of a deferred annuity is to provide a reliable income stream during retirement.
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The importance of deferred annuities in the modern world lies in their potential to serve as retirement savings vehicles. It can provide a reliable and predictable income stream during retirement years. In addition, they can offer financial security, peace of mind, and a source of income not dependent solely on social security or pension plans.
Table of contents
- What Is Deferred Annuity?
- How Does a Deferred Annuity Work?
- Example
- Benefits
- Taxation
- Deferred Annuity vs. Immediate Annuity
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- A deferred annuity is an insurance contract where the policyholder pays premiums during the accumulation period until retirement age and then receives a guaranteed monthly income for the rest of their life.
- The income received from the annuity is generally taxable at the policyholder’s income tax rate.
- Deferred annuities can provide additional income to older individuals to help supplement retirement income and cope with inflation and living expenses.
- Deferred annuities differ from immediate annuity plans because they have a deferred period before payments start. In contrast, immediate annuities typically start paying out within one year of the initial investment.
How Does A Deferred Annuity Work?
A deferred annuity is a smart investment strategy where investors regularly invest their funds into an annuity plan with an insurer, ensuring a monthly income stream during retirement or old age. With the flexibility to contribute any amount, the invested funds grow significantly during the plan’s tenure without incurring taxes. However, it’s important to note that when the scheme’s payout starts, it may attract an income tax rate.
The annuity plan comprises two distinct phases: the accumulation and payout phases. During the accumulation phase, investors regularly contribute small amounts until the age of 60, retirement, or maturity per the scheme’s terms. Additionally, during this phase, the invested amount accrues substantial interest. Subsequently, once the annuity reaches maturity, the payout phase commences, providing the investor with regular monthly payments post-retirement.
When investors choose to invest in a deferred income annuity (DIA) with an insurance company, their funds have the potential to earn interest through various types of contracts such as longevity, variable, fixed, and equity-indexed annuity. Moreover, DIAs offer additional features such as death benefits and future income guarantees, providing investors with a comprehensive investment solution that unlocks financial security and peace of mind opportunities.
Example
John, who is 35, decides to invest $100,000 in a deferred annuity with an insurance company. The annuity has a term of 20 years, during which John regularly contributes to the plan. Over the 20-year term, the invested amount accrues interest without being taxed. After the annuity reaches maturity at the end of 20 years, John can receive regular monthly payments as retirement income. This gives John a reliable source of income during his retirement years, making the deferred annuity a valuable long-term financial planning tool.
Benefits
A deferred annuity offers several important benefits, including:
- Tax-deferred growth: Earnings during the accumulation period grow without tax, allowing for potential compounded growth over time.
- Potential for higher growth: It may provide better growth potential than other investment options.
- Steady retirement income: It can provide a reliable and steady source of income during retirement, particularly in the later years of life.
- Potential for higher growth rates: Research indicates that deferred annuities in the US have historically experienced favorable growth rates yearly.
- Risk mitigation: Investing in it can help reduce the risk of depleting savings by retirement age.
- Tax advantages: This type function as a tax-advantaged savings plan, with taxes typically assessed only during the payout phase and at the current income tax rate.
- Guaranteed income: These investment options can provide a guaranteed income through monthly payments throughout the subscriber’s lifetime, ensuring financial security in old age.
Taxation
Deferred annuities operate similarly to individual retirement accounts (IRA) and 401(k)s. Like these retirement accounts, deferred annuities do not incur taxes on the income accrued during the accumulation phase. Instead, taxes only come into play when withdrawals are made, or the payout phase begins after accumulation. Additionally, all income and payouts are subject to taxation at the normal income tax rate per IRS regulations.
It’s important to note that premature or lump-sum withdrawals from the annuity plan can incur penalties. For example, suppose a subscriber decides to withdraw the accumulated amount in a single lump sum or before reaching the age of 60 years (at 59.5 years). In that case, the IRS may impose an early withdrawal penalty of 10% on the amount withdrawn.
Deferred Annuity vs Immediate Annuity
Let us see the difference between a deferred annuity and an immediate annuity in the following table –
| Feature | Deferred Annuity | Immediate Annuity |
|---|---|---|
| Premium Payments | Lump sum or part-by-part | Lump sum |
| Accumulation Period | Yes | No |
| Investment Option | Lucrative option alongside IRAs & 401(k) plans. | Option for return on investment during the pre-retirement phase. |
| Age to Start | After sixty years of age | Can start at any time above eighteen years |
| Taxation | Taxed on earnings and income depending on purchase by pre-tax or post-tax funds. | Taxed only on annuity earnings. |
| Application in Terminated Defined Benefit Pension Plans | No | Yes, provides benefits arising from terminated defined benefit pension plans. |
| Other Use | None | It can be used in a lawsuit settlement in a structured manner where the injured party receives monthly benefits from the other party. |
| Accessibility | Available to anyone with a stable job or income, it does not require a huge initial lump sum payment but only a small monthly premium for over 20 years. | Requires a huge initial lump sum investment, possible only when one has sufficient wealth. |
Frequently Asked Questions (FAQs)
It is a type of annuity where the policyholder makes a lump sum payment upfront to the insurance company, which then grows tax-deferred until it is withdrawn later, typically during retirement. This type of annuity is funded with a single premium and does not require any additional premium payments.
Flexible premium deferred annuity is a type of annuity that allows the policyholder to make premium payments at their discretion rather than in a lump sum upfront. As a result, the policyholder can choose when and how much to contribute. In addition, the annuity grows tax-deferred until it is withdrawn in the future, usually during retirement.
The present value of a deferred annuity refers to the current worth of the annuity, taking into account the time value of money and discounting the future cash flows back to the present. On the other hand, its future value is the estimated value of the annuity at a future date after it has grown with interest or investment earnings. Both present and future value are important considerations when evaluating a deferred annuity’s potential value and suitability.
Recommended Articles
This article has been a guide to what is Deferred Annuity. We explain its examples, comparison with an immediate annuity, taxation, and benefits. You may also find some useful articles here –
- Tax Deferred Annuity
- Deferred Annuity Formula
- Annuity Certain
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