An annuity is a reliable financial tool many use to secure their financial future. Many people looking to invest in their retirement use annuities because of the myriad of benefits they provide, such as tax-deferred growth and an additional revenue stream beyond Social Security.
There are two main types of annuities — deferred and immediate. Unlike immediate annuity contracts that disburse income payments immediately after purchase, deferred annuities delay income payments. This delay allows annuitants to gradually contribute to their accounts. It also allows for their investment to grow over time and benefit from compounding interest.
How Do Deferred Annuities Work?
Deferred annuities do not disburse income payments immediately. When you buy a deferred annuity, either through a single-premium payment or periodic payments, income savings are disbursed at a later date.
Deferred annuities are designed to supply annuitants with lifetime payments, or to carry over through a spouse’s lifetime after an annuitant’s death. Deferred annuities may be ideal investments for younger people or couples far off from retirement.
Deferred annuity contracts provide more control than an immediate annuity over the money invested. For example, deferred annuity owners can choose to receive periodic withdrawals, the entire investment as a one-time lump sum or transfer all assets to another account when their account reaches the annuitization phase.
All annuities are tax-deferred investments, meaning as the account earns interest, the annuitant is not immediately taxed on the growth. Instead, these earnings are taxed once they are withdrawn or annuitized. Fixed deferred annuities have a permanent rate of interest, and the option to include a death benefit rider. This rider, a component added onto an annuity, ensures all remaining assets are transferred to a beneficiary upon the annuitant’s death, preventing the investment from being forfeited to the issuing insurance company.
Fixed Deferred Annuity vs. Variable Deferred Annuity
There are two main types of deferred annuities: fixed annuities and variable annuities. While both options guarantee an income payout, the amount disbursed may differ depending on interest accrued over time.
A fixed deferred annuity guarantees the monthly, quarterly or yearly payments an annuity owner receives is consistent. During the accumulation phase — the period when the annuitant is building cash value for their annuity account — a fixed deferred annuity earns interest at a set rate of return. Consistent income payments are then disbursed and do not fluctuate every pay period.
Variable deferred annuity premium payments are invested into sub-accounts, and may accrue interest based on the performance of the financial market. This deferred annuity option carries a level of financial risk. Because funds are invested in stocks or mutual fund sub-accounts, the premium amount of the annuity may increase or decrease. This can cause the disbursement amount to fluctuate per pay period.