Retirement planning, simply put, is about preparing now so you’ll have enough income later. When you’re developing a retirement strategy, deferred annuities may be a building block to help supplement other income sources.
A deferred annuity is one way to provide guaranteed income for life. They are called “deferred” because the income payments begin later—on a date you decide. This can be two, five, or even 15 years from when you paid your first annuity premium. The deferment offers some tax advantages and allows you to put aside money for retirement when you are more likely to need income.
But how do you determine which deferred annuity may be right the best one for you? Let’s start by learning what deferred annuities are and how they work.
First, What is An Annuity?
An annuity is a contract between you and an insurance company. All annuities have one feature in common that makes them unique from other products: With an annuity, the insurance company promises to pay you a regular income for a period of time you choose—including the rest of your life—no matter how the markets perform or interest rates change.
Annuities can either be immediate or deferred. With immediate annuities, your payments begin right away and you are paid monthly, quarterly, or annually, depending on the payment cycle you choose. A deferred annuity is another way to provide guaranteed income for life—but, as mentioned above, income payments begin later and the premium you paid earns interest until you decide payments will begin. Plus, that interest is compounded, so your savings can grow even faster.
What Are the Types of Deferred Annuities?
There are two types of deferred annuities: fixed and variable. Both have their own differences and benefits. What annuity is best for you will depend on your financial goals and objectives, your tolerance for market losses, your other income sources, and your expected expenses in retirement. Only you and your financial professional can determine what annuity might be right for you, and familiarizing yourself with the benefits and features of fixed and variable annuities can help you decide which type might be a better fit.
What Do Fixed Deferred Annuities Do?
All fixed deferred annuities guarantee your money will earn at least a minimum rate of interest, and they may earn additional interest at a rate higher than the promised minimum. The additional interest rate is determined by the insurance company and can be in advance of your interest-earning period or at the end of the interest-earning period.
No matter how or when you earn additional interest, all fixed deferred annuities guarantee that you won’t lose any money in your annuity because of negative economic conditions or investment markets. The money (premium) you put into your annuity and the interest you have earned are locked in until you take it out. Because fixed deferred annuities provide the option to take payments later in life, they’re often used as a supplement to other retirement savings.
There’s no one “best” retirement strategy.
How Do Fixed Annuities Earn Interest?
Fixed annuities with interest stated in advance are called fixed rate annuities, and the insurance company calculates the interest rate based on the performance of the company’s own investments. With fixed rate annuities, the company also states how long the interest rate will be guaranteed, which can be one, two, or even five years.
There is another type of fixed annuity called a fixed indexed annuity. In this case, interest is calculated on changes to a market index, such as the S&P 500. Interest is calculated each year and the interest earned is based on increases to the index value, and is guaranteed never to be less than zero—even if the market index goes down. Although there are factors that limit the amount of interest you earn, the main benefit is that your principal can earn money each year if the market index goes up, and you don’t lose money when it goes down.
What are Deferred Variable Annuities?
Unlike fixed indexed annuities, money in a variable annuity earns a return based on how the underlying investment options you choose perform. These investments are called “sub-accounts” and they are invested in mutual funds or other investment products. Typically, your sub-accounts will have different amounts and types of risk. The sub-accounts you choose will affect the return you earn on your annuity, and they usually have no guaranteed return. However, some variable annuities offer a choice to put some of your money into a fixed account with a guaranteed minimum interest rate.
A deferred variable annuity has the potential to bring you higher earnings over time, but only you can decide if the appeal of potential gains and the risk of potential losses is right for you. In addition, some variable annuities could include higher fees to cover the investment choices, administrative costs, and contract charges.
Other Things to Know When Choosing Deferred Annuities
Like all tax-deferred savings options, withdrawals are taxed as ordinary income and you will be subject to a 10 percent penalty if you withdraw money from your fixed or variable deferred annuity before age 59½. If you won’t need the money until then, a fixed deferred annuity can provide you with steady, dependable income during your retirement.
Everyone is different, and everyone’s retirement plans are different. There’s no one “best” retirement strategy. Familiarizing yourself with the different types of deferred annuities can help you develop a retirement savings strategy today and in the future. By understanding all your options, you’re laying the groundwork for a retirement well spent.
Annuities are long term financial products designed for retirement income and may not be suitable for everyone. They involve fees, expenses and limitations, including surrender charges for early withdrawals. Some include optional riders and benefits that may come at additional cost. Annuity product and feature availability may vary by state.
Annuity guarantees are backed by the financial strength and claims-paying ability of the issuing company, and for variable annuities, do not apply to the performance of the variable sub-accounts which will fluctuate in value. Withdrawals are subject to ordinary income tax, and if take prior to age 59 ½ may be subject to an additional 10 percent federal penalty.