What Is a Deferred Annuity?

Annuities are an integral part of the retirement portfolios of investors who want a guaranteed stream of retirement income. A deferred annuity is a contract that provides the buyer with a steady stream of payments at a future date, compared to an immediate annuity that starts the payments right away.

“The way an annuity works is that you put your money into it, and there will be some form of a guarantee on the money,” says Robert Gilliland, managing director and senior wealth advisor at Concenture Wealth Management in Houston, Texas. “That could be a guarantee in the form of a stream of income or a death benefit.”

[Read: What Is a Retirement Annuity?]

What Is a Deferred Annuity?

An annuity is a contract with an insurance company that offers a guarantee in the form of a steady stream of income. You can purchase a deferred annuity with a lump sum payment or make payments over a set number of years. Deferred annuities have an investment phase and an income phase. “Where the deferred part of an annuity comes in is that you don’t start taking the money until some future date, because otherwise it would be an immediate annuity,” Gilliland says.

Deferred annuities have many benefits and drawbacks, and you should talk to a financial advisor and have an expert review your contract before signing on to what can be a complicated investment.

Types of Deferred Annuities

Deferred annuities can be structured in several distinct ways that affect how interest accumulates on your investment.

Fixed annuities. A fixed annuity pays a specified interest rate on your funds while they are invested. “You put money in, and it pays an interest rate,” Gilliland says. The predictable interest rate can be useful to retirees, but is not guaranteed to keep up with inflation.

Variable annuities. A variable annuity doesn’t guarantee a specific return. Instead, you can select investments such as mutual funds or exchange-traded funds, and your rate of return is subject to the performance of the investments. “A portion of their premiums are invested into mutual funds that are offered by that insurance carrier,” says Peter Landry, director of insurance and annuities at Wells Fargo. “The client can invest in those mutual funds and have the opportunity to have those proceeds grow over time, versus a fixed option.” Your investments might grow with the market and potentially keep up with inflation, but could also suffer losses.

Indexed annuities. The returns in an indexed annuity are tied to a market index, such at the S&P 500. There is usually a guaranteed minimum rate and a maximum rate of return. For example, you might have a minimum rate of 2% and a maximum of 6%, Gilliland says. Indexed annuities might allow you to get a higher rate of return than fixed annuities, but also have less potential for significant gains or losses than variable annuities.

[READ: The Pros and Cons of Immediate Annuities.]

When Does a Deferred Annuity Begin Payments?

When your deferred annuity begins to make payments depends on how the insurance contract is structured. You might opt for a lifetime deferred annuity that provides future payments for the rest of your life, regardless of how long you live. However, the payments stop if the annuity holder dies, even if that’s not very long after payments start.

A joint and survivor annuity continues to make payments to a spouse or survivor if the annuity holder dies. However, the payments are lower due to the risk of paying over two lifetimes instead of one.

A period certain annuity pays benefits for a set period of time rather than a lifetime. The payments are provided over a fixed amount of time, such as 10 or 20 years. If you pass away during the payment period, payments can continue to a beneficiary. However, if you live longer than the payment period, payments will stop.

Advantages of a Deferred Annuity

Annuities provide a guaranteed lifetime income, much like traditional company pensions. People who want a guaranteed income for life can achieve that with a deferred annuity.

Contributions to deferred annuities are tax-deferred, much like an IRA or 401(k), and the funds are not taxed until they are withdrawn from the account. “The tax gain is deferred until some period of time,” says Dan Hawley, president of Hawley Advisors Wealth Planning in Walnut Creek, California.

Unlike 401(k)s and IRAs, there’s no limit on how much you can contribute to a deferred annuity. Those who have already maxed out other types of retirement accounts can qualify for additional tax breaks using a deferred annuity. “That’s really the primary benefit of that deferred annuity is it provides another tax deferral vehicle, just like their 401(k) or their traditional or Roth IRAs,” Landry says. “If they’ve maxed out on those options in terms of income level on their IRA or capped out on their 401(k), it’s another vehicle to create tax-deferred income growth.”

Disadvantages of a Deferred Annuity

One of the biggest drawbacks of deferred annuities is that your financial flexibility is restricted. You are buying a contract and it will cost you part of that money to cancel the contract and regain full control of your funds. The fees and penalties for making changes can be high.

Deferred annuities generally have long and complex contracts, and it can be difficult to understand all the fees you might be charged. Insurance salespeople often receive commissions for selling annuities, which could encourage them to sell annuities to people regardless of whether they are a good fit for their financial plan.

Who Should Buy a Deferred Annuity

Those who want a guaranteed income stream in retirement might choose a deferred annuity for a portion of their assets. “If you have a $10,000 a month need for income and $3,000 is going to come from Social Security, depending on the annuity you can get another $2,000 from that annuity,” Gilliland says. “So, you have 50% of your needs, in effect, guaranteed for retirement.”

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What Is a Deferred Annuity? originally appeared on usnews.com

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