A deferred annuity is a contract between you and an insurer that guarantees a stream of income in return for a lump-sum payment or a series of payments over time. But unlike immediate annuities, where you start receiving income payments shortly after you purchase your contract, with a deferred annuity you’ll make your premium payments first, and your annuity will start paying you back at a later date, which can be several years into the future.
During the time you contribute payments, your money grows at an interest rate based on the type of annuity you choose — it can be fixed, indexed, or variable.
A deferred annuity is unique because you need to wait at least a year before you’ll receive any income from it, but many deferred annuities can last five, 10, and up to 20 years. The longer you wait to start receiving income payments, the more time your annuity will have to grow.
What is a deferred annuity?
If “deferred” is in the title of your annuity, it means that there’ll be a delay of at least one year — but usually many years — between the time you pay all of your premiums and the time you start receiving financial benefits from your annuity.
Learn more about other types of annuities
How do deferred annuities work?
With a deferred annuity, you’ll fully fund your annuity contract first, either through a lump-sum payment or a series of payments over time. Then, after a specified period of time — of at least one year, but usually a few years into the future — the annuity will start paying you back for a specific period of time set in your contract, including the rest of your life. [1]
The period of time during which you contribute money to fund your contract is known as the accumulation period and is a distinctive feature of deferred annuities — immediate annuities don’t have accumulation periods because they start making income payments back to the contract owner right away. During the accumulation period, your money grows on a tax-deferred basis.
Premiums
You can pay the premiums of a deferred annuity in one lump sum or in several installments, based on your resources and the terms of your contract. Once your annuity is fully funded, you’ll need to wait at least a year before you can start receiving any income payments.
Accumulation period
The accumulation period is the time between when you finish paying your premiums and when the annuity starts paying you. [2] For a deferred annuity, the accumulation period will last for at least one year, although for many annuities, the accumulation period can last for several years.
Annuitization or payout phase
Once the accumulation period ends, your annuity is ready for the next phase, known as annuitization. During this period, the insurer will repay your premiums back to you plus any gains in the form of income payments.
There are several ways to annuitize your contract. You can set up an income stream to last for a set number of years or for the rest of your life. You’ll also have the option to be paid out in a lump sum, although this option is less common for people to choose.
People often use annuities to set up an income stream in retirement to supplement their Social Security income or funds from other retirement accounts. That’s why some deferred annuities offer the option to delay the start of your income payments for up to 20 years.
Surrender period
The surrender period is a time frame where you’ll be penalized if you cancel your annuity contract or withdraw money from it beyond the amount allowed by the terms of your contract — some annuities let you withdraw up to 10% of your funds annually without having to pay a fee, but every annuity contract is different.
Your surrender period will typically last up to seven years, although the exact terms will be clearly expressed in your contract. [3] Surrender fees may decrease gradually — you might have to pay, for example, a 7% fee to take a withdrawal in the first year, and only 1% in the seventh year. In other words, the sooner you surrender your annuity, the higher your penalty will be.
Since annuities are tax-advantaged accounts, you’ll also have to pay a penalty fee if you withdraw money from your contract before age 59½.
Fees & penalties
If you cancel your annuity before the annuitization ends, you’ll get some of the money back from your annuity early, but you’ll also have to pay additional fees and penalties. The exact amount you’ll have to pay in penalty fees will be clearly stated in the terms of your contract. Fees can sometimes be as high as 7% of the principal you paid.
“Annuities are complicated,” says Laura K. Cook, certified financial planner at Flourish Financial Life Planning, LLP. “Surrender periods last different lengths of time depending on the exact policy. Surrender periods typically last for seven years, but they can be as long as 15 years. The surrender period is usually tied to the commission schedule that the [seller] receives.”
Depending on the type of annuity you purchase, you may also have to pay administration fees, commissions, and mortality and expense risk charges, which insurance companies charge in order to manage the investments in your annuity contract and to buffer against potential losses.
These fees and commissions can be at least 1% per charge, depending on the specific terms of your contract. Combined, they can cut significantly into your returns.
Make sure to consult with a financial advisor before purchasing an annuity in order to understand all the fees that will be included in your contract and get a sense of the potential accumulated value of your annuity.
The accumulated value of your contract will be the total of the premiums you’ve contributed plus any earnings, minus any withdrawals and fees charged by the insurance company.
Guarantees & riders
If you set up a fixed annuity, it’ll come with a guaranteed rate of growth. But other annuities, like variable and indexed annuities, are dependent on market performance and may not guarantee a minimum rate of growth. With these annuities, there’s more risk, but also more growth potential.
In order to buffer your annuity investments from potential losses, you’ll also have the option to add riders to your policy. These are add-ons that offer additional financial protections in certain circumstances. Some riders offer living benefits — which can buffer against inflation or potential losses, or guarantee a stream of income for life — and others offer death benefits — which can guarantee a return of your premiums or pay out to your chosen beneficiaries if you die before the full accumulated value of your annuity has been paid out.
While these riders can offer guarantees and peace of mind, you may also have to pay an extra fee “for having those benefits attached,” Cook says. A financial advisor can help you decide whether it’s worth it to add specific riders to your contract.
Tax implications
Deferred annuities allow your money to grow on a tax-deferred basis — this means you’ll only have to pay taxes on your funds when you receive them as income payment. When you receive your annuity payouts, they’ll be made up of both the original principal you paid in and any growth that’s accumulated over time.
If you purchase your annuity with money that’s already been taxed — for example, with savings, the sale of a large asset, or even funds from a windfall — you’ll only have to pay taxes on the portion of income payments you’ll receive that’s considered earnings. This is known as a non-qualified annuity.
If, on the other hand, your annuity has been funded with pre-tax dollars and is held in an employer-sponsored retirement plan, such as a 401(k), or in an individual retirement annuity (IRA), then your contract will be considered qualified. When it comes to qualified annuities, you’ll have to pay taxes on any portions of the principal and returns that you receive as income payments.
Another distinction between both types of contracts is that qualified annuities are considered retirement accounts and therefore subject to contribution limits by the IRS.
For 2024, the maximum annual contribution you can make to an IRA is $7,000 if you're under age 50. If you’re 50 years old or older, you can contribute $8,000.
If your annuity is held in a 401(k) plan, the maximum annual contribution you can make every year is $23,000 if you’re under age 50, or $30,500 if you’re age 50 or older.
Non-qualified annuities aren’t subject to the annual IRS contribution limits. You can contribute as much as you want according to your insurer’s guidelines.
What are the different types of deferred annuities?
There are many different types of deferred annuities on the market, mostly depending on how your principal is invested. These are the most common.
What is a fixed deferred annuity (FDA)?
Fixed deferred annuities (FDAs) are a straightforward annuity contract where your funds grow at fixed interest rate set by the insurance company. You know exactly how much you’ll pay, how fast your policy will grow, and what your payments will be.
While your rate of growth is guaranteed, you’ll give up the chance to have more lucrative growth that you might get with other types of annuities, like indexed or variable annuities.
If you want to take a conservative approach to investing and are risk-averse, FDAs might be a good option for you.
Learn more about fixed annuities
What is an indexed deferred annuity?
An indexed deferred annuity is unique in how the funds grow. Instead of having a fixed rate of growth, your annuity will be dependent on the performance of a market index — for example, the S&P 500.
When the market does well, your payments may increase up to a certain point — indexed annuities usually come with participation rates and caps that may limit the growth of your returns. But when the market goes poorly, your potential losses might be mitigated by a floor feature, which limits your investment risk.
You might consider indexed deferred annuities if you have moderate risk tolerance and you’re looking for a longer-term investment vehicle, rather than an immediate income stream.
Learn more about indexed annuities
What is a variable deferred annuity?
A variable deferred annuity lets you choose how your premiums will be invested. You can choose from a variety of stocks, bonds, mutual funds, and market indexes. The principal on your annuity will grow based on how your investments perform in the market.
This means that your annuity has a higher growth potential compared to a fixed or indexed annuity, but you’ll also take on more risk of slower growth or even a loss, depending on how your investment accounts perform.
Variable annuities can work for people who can tolerate market volatility and potential losses, and who are familiar with how the market works.
Learn more about variable annuities
What is a deferred income annuity?
A deferred income annuity simply refers to an annuity contract that’s specifically designed to create a stream of income for you at a later time. Many people set up deferred annuities in retirement to supplement their income from Social Security and other retirement plans.
What are the pros & cons of deferred annuities?
Deferred annuities allow you to let your money grow, potentially increasing the amount of your future income payments, but they come with fees and commissions that might eat into your accumulated value — and you’ll have to wait a few years before you start receiving a stream of income.
These are other pros and cons of deferred annuities to consider.
Pros
Tax-deferred growth. Once your annuity is fully funded, it’ll grow tax-deferred. You won’t pay any taxes until you start receiving income payments.
Flexibility. You’ll have the freedom to determine how you’ll make premium payments, how the funds on your annuity will grow, and how you’ll be paid out.
Room to plan ahead. A deferred annuity lets you create a long-term plan to set yourself up for financial success many years into the future.
Cons
Lack of liquidity. Setting up a deferred annuity allows you to create a long-term financial plan, but if your needs change or you need to cash out your annuity early, it could cost you a lot of money in fees and taxes.
Cost. Deferred annuities can have higher administrative fees and surrender charges compared to other types of annuities. It’s best not to set up a deferred annuity unless you know the time frame will work for you.
Complex contracts. The details of your deferred annuity contract can be hard to understand, so if you do select this type of annuity, it’s necessary to work with a financial advisor that you trust.
What should you consider before buying a deferred annuity?
Annuities can be a great financial tool, but they’re not for everyone. Consider factors like your age, investment goals, and risk tolerance before you purchase a deferred annuity.
Your age
Your age will play a key role in determining the type of annuity you choose. Deferred annuities are a good fit for people who don’t need to start receiving a stream of income right away — in fact, the best way to take full advantage of a deferred annuity is by waiting several years to start receiving payments.
The longer you wait, the more your annuity will grow. If you need to start receiving payments as soon as possible, consider an immediate annuity instead.
Your investment goals
A deferred annuity can be a good financial tool only if it ultimately aligns with your longer-term investment goals.
Many annuities can have accumulation periods of five, 10, and up to 20 years before the annuitization phase starts. If you have less time to invest your money, consider an immediate annuity, which will start paying you within 12 months of setting up your contract.
Your risk tolerance
A deferred annuity can generally work for your investment goals whether you’re more aggressive or more conservative. If you’re more risk-averse, a fixed annuity will be a better fit, because it grows at a reliable rate. If you have a higher risk tolerance or more ambitious growth goals, a variable or indexed annuity will likely be a better fit.
The best way to determine if a deferred annuity is right for you is “if you have ‘safe money,’ meaning money that you aren’t currently using and want to put toward your retirement goals,” says Amy Shirk, sales agent at Policygenius.
Who should consider deferred annuities?
You should consider a deferred annuity “if you don’t need annuity payments immediately and want to wait until a later date to receive the payments,” says Tony Boyden, learning partner at Zinnia.
Deferred annuities are best for people who have money that they want to use to fund their retirement, but don’t anticipate needing a supplemental income for at least a year.
If you’re not sure if an annuity will fit in your financial plan, speak with an advisor at Policygenius who can offer you transparent, unbiased advice.
