What Is a Deferred Annuity?

Kevin Dyreson is a senior director of Risk Product Positioning at Northwestern Mutual.

When it comes to saving for retirement, accounts like 401(k)s and IRAs get most of the attention. But they’re not the only options available. One option that some people overlook is an annuity. Annuities can help you save for retirement and help you create an income stream similar to a “paycheck” in retirement.

There are many different types, which all work slightly differently and can help with different goals. A deferred annuity is one popular type that works well in some situations.

Below, we take a closer look at what a deferred annuity is and how it works. We also walk through the pros and cons that may come from incorporating a deferred annuity into your financial plan.

What is a deferred annuity?

A deferred annuity is a financial tool that you can purchase from a life insurance company to accumulate funds that you intend to use in retirement. The funds you add to a deferred annuity can grow tax-deferred over time. Eventually, you’ll be able to withdraw the funds, convert them into a stream of income in retirement or do a mix of both.

How does a deferred annuity work?

A deferred annuity generally has two phases: the accumulation phase and the payout phase.

Accumulation phase

During the accumulation phase, you will not get any payments from your annuity. Instead, the annuity is growing in value. This growth in value typically comes from three sources:

• Contributions you make
• Interest earned on those contributions
• Growth of underlying investment funds

The rate at which your contributions grow will depend on the terms of your annuity contract and are especially dependent on the type of annuity you choose—whether it is a fixed, variable, or indexed annuity. You can learn more about these options below.

Regardless of the type of annuity you own, any interest you earn is reinvested alongside the principal, allowing you to take advantage of compound interest. The growth of any underlying investment funds would also continue to grow tax-deferred.

During the accumulation phase, any growth (interest or investment performance) is tax-deferred. That means you won’t owe income taxes until you begin receiving payments in the future. 

Payout phase

During the payout phase, you’ll begin receiving money from your annuity. This can take the form of a single or multiple lump-sum distributions. Some people opt to convert their annuity into an income plan that will provide a series of regular, recurring payments—typically for as long you live.

Keep in mind that the annuitized payments you get will be made up partially of your contributions and partially of any growth your principal enjoyed. You’ll typically owe income taxes on any growth you receive. Exactly how much you owe will depend on your current tax bracket. Single or multiple lump-sum distributions will be taxed as gains first.

Early withdrawal

You might need to withdraw money from your annuity before you reach the payout phase. While it’s possible, making an early withdrawal can be quite costly.

Gains on any cash withdrawals you make before turning 59½ could result in a 10 percent early withdrawal penalty from the IRS. You’ll also owe income taxes on any growth above the principal that you paid into your annuity. And if you make a withdrawal during your annuity’s surrender period, you may owe the insurance company a surrender penalty.

Types of deferred annuities

Deferred annuities come in several varieties—fixed, variable and indexed—each of which works a little differently and will have pros and cons based on your individual needs. We highlight these differences below:

Fixed deferred annuities

With a fixed deferred annuity, your annuity’s rate of growth is guaranteed for a specific period of time. No matter how interest rates and investment markets perform, each year your annuity will grow according to the rate set in your contract. When you purchase a fixed deferred annuity, you’ll know exactly how much growth you can expect to see during the guaranteed period.

Due to the guaranteed rate of growth, fixed deferred annuities may be a good match for more conservative investors.

Variable deferred annuities

With a variable deferred annuity, your annuity’s rate of growth is dependent on the performance of the underlying investment funds that you choose. These investment funds can allow you to get exposure to market-based investments that can fluctuate from year to year. While it’s possible that a variable annuity will outperform a fixed annuity, it’s also possible that it will underperform—or even lose money. Because of this variability, it’s impossible to know what the final value of your annuity and eventual payments will be.

Variable deferred annuities are typically seen as carrying higher risk than fixed deferred annuities and are typically better suited for investors willing to take on more risk for the possibility of higher returns.

Indexed deferred annuities

With an indexed deferred annuity, your annuity’s rate of growth is dependent on the performance of a preselected market index (such as the S&P 500 or NASDAQ) it tracks. The better the underlying index performs, the more your annuity will grow. As is the case with a variable annuity, this performance isn’t guaranteed, making it difficult to project your annuity’s future payments.

Unlike variable deferred annuities, indexed deferred annuities often have caps, participation rates and/or spreads to limit the upside potential of future returns. These rates can be changed by insurance companies after the contract is issued. Indexed deferred annuities are considered more complicated than variable deferred annuities and fixed deferred annuities. The limited upside growth potential can turn off some investors, while more conservative investors might be concerned with the complexity and unpredictable returns.

Benefits and drawbacks of deferred annuities

Understand the pros and cons before you decide whether a deferred annuity deserves a place in your financial plan.

Benefits

• Tax-deferred growth: You won’t pay income taxes on any growth your deferred annuity sees until you withdraw money from your annuity or start receiving payments. Depending on your tax bracket during your working years and retirement, this could lead to significant tax savings.
• Potential death benefit: Many deferred annuities come with a death benefit that would protect your contributions to the annuity. Some deferred annuities will have a death benefit feature that can rise or lock in previous growth from the annuity.

Drawbacks

• Complex contracts: Some annuity contracts can be complex. Your financial advisor can help you work through a contract so that you understand it.
• Liquidity: Deferred annuities are designed for the long term. That means they offer the best value over time. However, if you think you’ll need money in the short term, it may be difficult to access in a deferred annuity.
• Potentially high fees: Like most financial products, an annuity charges fees. While some annuities have low fees, the costs on others can add up. Know what fees you are agreeing to before you purchase. 

Who should consider a deferred annuity?

The power of deferred annuities lies in their ability to compound and grow over time. The longer your money grows, the more income you could eventually create. This means that a deferred annuity can be especially beneficial to younger savers with an eye on retirement—especially those who have already maxed out contributions to their 401(k)s, IRAs or other tax-advantaged retirement accounts.

Beyond this, a deferred annuity can be a good fit for anyone looking to secure a source of retirement income along with Social Security. It can work alongside Social Security and a 401(k) to diversify your sources of income in retirement.

Keep in mind that a deferred annuity may not make sense for everyone. Whether or not it fits will depend on a number of factors, including your risk tolerance, investment timeline, financial goals and your broader financial plan.

Your Northwestern Mutual financial advisor will get to know you. They will look at your insurance and investments and create a comprehensive financial plan that shows you how everything works together. That way, you can be confident knowing if a deferred annuity is right for you.

Your advisor can also take a broad look at your money and help you identify blind spots and opportunities that might otherwise be overlooked. You can see how to use multiple financial options that work together to help you protect and grow your wealth.