Definition
A deferred annuity is a type of insurance contract that promises to pay the buyer a regular stream of income, or a lump sum, at some future date. The periods of payments may be fixed or variable. The delay or “deferral” period can be of any length, and it provides potential for an investment to grow as it holds off payments until the investor elects to receive them.
Key Takeaways
- A Deferred Annuity is an insurance contract in which the payer contributes funds for a certain period of time before they begin to receive regular payments. This is called the accumulation phase.
- The main attraction of the Deferred Annuity is the tax benefit it provides. Funds contributed to the annuity are not subjected to taxes until they are withdrawn or distributed.
- Deferred Annuities can either be fixed or variable. A fixed deferred annuity offers a guaranteed interest rate, while a variable deferred annuity’s returns are linked to the performance of an investment portfolio.
Importance
A deferred annuity is important in finance primarily because it provides a mechanism for individuals to accumulate savings on a tax-deferred basis, and later generate a stream of income during retirement.
It offers the annuitant the ability to grow their investment over time with the added benefit of delaying taxes on the earnings until funds are withdrawn, which can potentially lead to larger gains compared to a taxable investment account.
This financial tool can be particularly beneficial for those in higher income brackets during their earning years who anticipate being in a lower tax bracket in retirement.
Lastly, it gives individuals the flexibility to control when they start receiving income payments, empowering them to strategically plan their retirement income distribution.
Thus, understanding deferred annuity is crucial for effective retirement planning and wealth management.
Explanation
A deferred annuity primarily serves as a method of income planning to support individuals during their retirement years. The main purpose is to provide a steady stream of income in the future, which is prepared and financed long before the payouts begin.
Essentially, it helps individuals to accumulate savings over a certain period (deferral period) and then distribute these savings in the form of regular payments. This can be particularly useful for people who want to ensure financial security when they no longer have a regular income from their job or business.
Investing in a deferred annuity is designed to help you grow your savings in a tax-efficient manner. Since taxes on any investment gain are deferred until withdrawal, this allows your investment to compound and grow more quickly than a comparable taxable investment.
This advantage can be crucial in making your money go further in retirement. Further, depending on the type of deferred annuity product, there can be potential to invest in a variety of assets such as bonds and equities to potentially increase the return on investment.
Examples of Deferred Annuity
Retirement Savings: The most common example of a deferred annuity is in retirement planning. Individuals often choose these annuities as part of their individual retirement account (IRA) or 401(k) to defer income until after retirement. During their working years, they make contributions into the account. Once they retire, they will start receiving regular payments.
Long-Term Investment: If an individual inherits a large sum of money, they might choose to put this into a deferred annuity. Over a period of time, the money will accumulate interest. After a certain age or time period, the annuitization phase will start where the individual will start to receive regular payments. This can provide a stable source of income later in life.
Education Planning: Deferred annuities can also be used by parents or grandparents to save for a child’s future education expenses. Contributions can be made over a period of years while the child is still young. By the time the child is ready for college, the account can be annuitized to help cover the costs of tuition and other expenses.
FAQs on Deferred Annuity
What is a Deferred Annuity?
A Deferred Annuity is a contract with an insurance company that promises to pay the owner a regular income, or a lump sum, at some future date.
What are the two phases in a Deferred Annuity plan?
Deferred Annuity plans have two phases: accumulation and payout. The accumulation phase involves making payments into the annuity. The payout phase is when you start receiving regular payments.
Does a Deferred Annuity have any tax benefits?
Yes, a key advantage of Deferred Annuities lies in their tax-deferred growth. You don’t pay taxes on the interest, dividends, or capital gains accumulating in the annuity until you begin withdrawing the money.
Can I withdraw from a Deferred Annuity before its maturity date?
Yes, you can withdraw money from a Deferred Annuity before its maturity date. However, withdrawals made before age 59 1/2 may be subject to a 10% early withdrawal penalty by the IRS, and you may also be charged a surrender fee by the annuity company.
What is the difference between a Deferred Annuity and an Immediate Annuity?
The primary difference between an Immediate Annuity and a Deferred Annuity lies in when payout begins. With an immediate annuity, the investor begins to receive payments right after investing. With a deferred annuity, payouts start at a later date, chosen by the investor.
Related Entrepreneurship Terms
- Annuitization
- Accumulation Period
- Beneficiary
- Fixed Deferred Annuity
- Variable Deferred Annuity
Sources for More Information
- Investopedia: It is a reliable website that simplifies complex financial information and decisions for its readers.
- Fidelity: Fidelity is a broad financial services company that can provide well-rounded insight into deferred annuities.
- The Balance: The Balance makes personal finance easy to understand. It is a free resource for all things finance.
- NerdWallet: NerdWallet offers financial tools and advice to help people understand their options and make the best possible decisions.
