It would be more accurate to separate immediate and deferred annuities into categories rather than types, since all different types of annuities can be classified as either immediate or deferred. Both immediate and deferred annuities can be fixed or variable and they offer various pros and cons depending on your retirement goals and income needs.
The primary difference between these annuities is that immediate annuities don’t have an accumulation phase. An accumulation phase is a period of time that lapses between when the owner purchases the annuity, and when they start receiving payouts. Deferred annuities have an accumulation phase and a payout phase. During the accumulation phase, the money you put into the annuity grows tax-deferred until withdrawn, as either a lump sum or a series of payments. With these annuities, you decide when your money becomes taxable, one of their key benefits.
It is important to note that many investors use annuities only as tax-deferred accumulation vehicles and never activate the income payout phase.
Immediate annuities, otherwise known as income annuities or single premium immediate annuities (SPIA), are considered the oldest and most traditionally understood annuities. Using these straightforward annuities, the owner makes a lump sum payment to an insurance company in exchange for their contractual obligation to make income payments beginning on the date, at the agreed upon frequency, and for the duration defined in the annuity contract. Immediate annuities can be considered, personal pensions.
At AnnuityAdvantage, we guide you through the annuity selection process to ensure you choose the one that best fits with your retirement needs. Choosing an annuity largely depends on if/when you require income, how much risk you’re willing to accept or wishing to avoid, and whether you want to incorporate a tax-deferred accumulation strategy into your planning. We believe you should fully understand your annuity before making any decisions, and we do all we can to empower you with that knowledge.
Before diving into the differences between immediate and deferred annuities, let’s look at what annuities are and the basic purposes they serve in retirement planning. Annuities are long-term financial products issued by insurance companies designed to protect you from outliving your income. You can purchase an annuity to either protect and grow your retirement savings or provide yourself with guaranteed income.
Understanding immediate annuities comes down to a few factors. First, immediate annuities don’t have an accumulation phase. An accumulation phase refers to the time between when the owner begins putting money into the annuity and when they start receiving payments. So, immediate annuities take effect as the name suggests, immediately. In this model, you have quick access to your guaranteed income payments.
Another appealing aspect to immediate annuities is the payment term customization options they feature.
With period-certain-only-annuities, payments are made for a predetermined amount of time. If the annuitant dies before the end of that period, payments continue, to the named beneficiary, for the remainder of the agreed-upon term. At the end of the period-certain term, the payments stop regardless of whether the annuitant is alive or not. With period-certain-only annuities, it is possible for the annuitant to outlive payments.
You can purchase immediate annuities with either qualified or non-qualified funds. Qualified funds refer to funds contained in a tax-qualified account, such as an IRA or 401(k). Because these funds are contained in these types of accounts, they are considered taxable by the IRS (excluding ROTH). Non-qualified funds refer to savings or investment holdings that the IRS has already taxed, and are not held within a retirement account.
If you pay for an immediate annuity with qualified funds, the entirety of your payment is taxable as income (excluding ROTH). If you purchase an immediate annuity with non-qualified funds, a portion of the monthly payments has already been taxed and is considered a return of principal. The non-taxable portion is represented as a percentage that is called an exclusion ratio, a term describing how much of your monthly payment is excluded from taxes.
Deferred annuities work slightly different than immediate annuities. These types of annuities have what’s known as an accumulation phase. The accumulation phase delays payouts resulting in tax-deferral benefits, during which time your annuity can grow and compound in value. There are many different types of deferred annuities, including; fixed-rate or multi-year guarantee annuities (MYGA) and fixed indexed annuities (FIA).
Deferred annuities offer a distinct advantage when considering the added earnings capacity of tax-deferred interest. Simply compare it to fully-taxable earnings and you’ll quickly see the advantage.
Consider a $90,000 investment with a 4.0% interest rate. At a 28% tax bracket that means you would lose around $1,008 in taxes the first year. That would only leave $2,592 to compound over the next year. If you were to defer the taxes, the full 4% in interest earnings would compound, and that added compounding benefit would continue for years to come. As you can see, the longer you can defer your tax obligations, the more compounded interest you can accrue, and the more earnings your annuity will generate.
The payout phase for deferred annuities begins when you decide to annuitize your contract and take guaranteed lifetime income from your annuity. Annuitization is optional, until it becomes mandatory at a very advanced age (Maturity Date), per the terms of the annuity contract. Many annuity owners never annuitize their contracts. However, the ones that do typically make that decision while in retirement, but you can do so as your needs dictate. You can withdraw funds during the accumulation phase via partial withdrawals or a complete cash-out contract surrender. You can also exchange your annuity for a better offering from a different insurance company via a tax-free 1035 exchange. But be aware of any potential early surrender charges and market value adjustment (MVA) fees. Finally, there’s always the option of converting your existing deferred annuity into a stream of guaranteed lifetime income payments via annuitization.
You might confuse the contract’s maturity date with the length of the interest guarantee period or surrender penalty term. The maturity date is specified in the annuity contract as the time when the owner must select a settlement option and begin receiving payments. The interest guarantee period or surrender penalty term describes the period of time when the contract is subject to surrender fees or early withdrawal penalties.
Immediate annuities and deferred annuities really serve two different purposes. Immediate annuities are for those that need income right away, and deferred annuities are for those that would like to grow their money on a tax-advantaged basis. As previously mentioned, one of the main advantages of a deferred annuity is the increased compounding of interest earnings you can generate by deferring taxes. However, if you need access to your funds in the near future or need to generate income now, deferred annuities carry the potential to tie up funds.
Immediate annuities might be the ideal way to secure a source of guaranteed retirement income if you need your payments to start right away. Though you won’t realize some of the tax-deferred accumulation benefits of a deferred annuity, you will benefit from receiving income as soon as you purchase the annuity.
Whether you choose an immediate or deferred annuity, you should carefully review the contract to ensure you understand all of the pertinent details. You should also compare offerings from other insurance companies to decide which annuity fits your needs best.
Having an annuity firm you trust is critical when choosing the best annuity for your financial goals. Because annuities can be highly complex financial contracts and buying one can have substantial consequences during your retirement, you should only purchase an annuity if you trust your annuity agent and have been fully informed. There’s no need to rush your decision. A reputable firm will gladly walk you through your options and explain how they will affect your retirement strategy so you can choose the one that best fits your needs.
The primary difference between immediate and deferred annuities is that immediate annuities don’t have an accumulation phase. Immediate and deferred annuities can both be fixed or variable and choosing between an immediate and a deferred annuity often comes down to how urgently you need your income. It also depends on whether you want to use the annuity for its tax deferral benefits. With deferred annuities, you won’t have to pay taxes on your annuity during the accumulation phase as long as you leave the interest earnings inside the contract to grow and compound. This has the potential to help provide higher income opportunities in the future.
At AnnuityAdvantage, we only care about whether your annuity fits your retirement criteria. That’s why we walk you through all of the options to ensure you’re comfortable with your choice. Whether you want access to immediate income or you prefer a deferred annuity for its increased income potential down the road, we do everything we can to ensure you are fully informed and leave AnnuityAdvantage feeling confident about your retirement. Contact our annuity agents today to learn more about what annuities can do for your golden years.
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