All About Deferred Annuities
If you’re looking ahead to retirement and want to ensure a certain level of income during those years, you may want to consider a deferred annuity.
The term ‘deferred’ refers to when you begin drawing income from the contract. With an immediate annuity, you begin receiving income as soon as you enter into the contract with the insurer. With a deferred annuity, you are deferring income, which means you are choosing to receive income at a later date.
How deferred annuities work
A deferred annuity is a contract with an insurance company. You make a single purchase payment or a series of payments to the company. In exchange, the company promises to make regular payments to you or a payee you specify, starting at a specified date for a designated period of time.
You do not have to decide when to begin taking income when you purchase the contract. Within certain limits, you can contact the insurance company at almost any time to begin your income stream. The annuity can provide a lifetime stream of income or payments over a contractually defined term. The amount of income will be based on the annuity’s account value at the time you convert it into an income stream, a process known as annuitization.
Deferred annuities can be variable, fixed or indexed, terms that describe how the annuity’s account value earns interest.
Another option you can have with deferred annuities is how to fund them. With a single premium deferred annuity, you make a single premium payment at the beginning of the contract. A flexible premium deferred annuity, on the other hand, allows you to make several deposits, and the amounts can vary.
You will be required to leave most or all of the money in the annuity for at least a set period of time before you can take withdrawals. This will be determined before you purchase the annuity. The length can range from 3 to 15 years. At the end of that period, called a surrender period, you can either begin taking income or leave the money in the annuity. Keep in mind the longer you wait to annuitize your contract, the more income it will generate.
Deferred annuities charge annual fees that include a mortality and risk expense charge, and an administrative fee. There will also be fees for any optional benefits (see below).
Free withdrawals and surrender charges
If you decide to remove some or all of your money from the annuity before its surrender period, you will likely have to pay a surrender charge. This is typically a percentage of the amount withdrawn. The percentage will decline over time. For example, your annuity may have an 8 percent surrender charge if you withdraw funds in the first year, a 7 percent charge in year 2 and a 6 percent charge in year 3.
Many annuities, however, offer a free withdrawal percentage. This provision allows you to take out a percentage of the annuity’s value without a charge. A typical free withdrawal amount is 10 percent of the account value.
What happens if you pass away before receiving any income? Deferred annuities offer a basic death benefit. If you die during the accumulation period, your beneficiaries will receive some or all of the annuity’s account value at the time of your passing.
Once you begin taking income, there is no basic death benefit, but there are options for beneficiaries to receive part of the annuity’s value (see below).
How deferred annuities are taxed
Money deposited in a deferred annuity grows tax-deferred until you take distributions. Because of this, you must wait until age 59 1/2 to withdraw funds from the annuity. Doing so prior to age 59 1/2 will result in a tax penalty. There are also required minimum distributions (RMDs) starting at age 70 1/2, similar to a 401(k) and IRA.
You will not pay tax on the portion of your payments that is considered a return of your original premium. The taxable portion is what your annuity pays above and beyond what you put into it. For example, if the value of your annuity doubles what you deposited, then half of your income withdrawals will be taxed as regular income. The other half will be considered a return of your principal.
If you transferred money from a 401(k) or IRA, your annuity payments will be taxed as regular income, since you would not have paid taxes on the gains in those investments prior to depositing them in the annuity.
Optional features and benefits
Insurance companies offer some options to these products to make them more flexible, including:
Income rider: This is an optional benefit that can be attached to an annuity for an additional annual fee. It provides a lifetime income stream that you can turn on in the future. It also gives you the flexibility of stopping income and restarting it again. The value of an income rider grows at a contractually guaranteed rate. This value is not available for a lump sum, only as a source of lifetime income payments.
Premium bonus. Some companies offer a bonus at the beginning of the contract, typically1 percent to 5 percent of the amount of premium you pay. So if you put $100,000 into a variable annuity with a 5 percent premium bonus, your contract will begin with a value of $105,000, minus fees and expenses. Keep in mind that fees and expenses may be higher with a premium bonus product than with a regular annuity.
No surrender charges. Some annuities offer contracts with no surrender periods, which means no charges for withdrawing money. However, the fees for these annuities will be higher than for those with surrender periods.
Return of Premium. This type of immediate annuity guarantees you or your beneficiaries will receive an amount equal to your initial premium, regardless of when you pass away.
Increased income for confinement or illness. Another new option some companies offer is an increase in the income payments, up to double, in the event you become terminally ill or confined to a nursing home or other care facility. This feature is often included with an income rider.