Deferred annuity

Definition

A deferred annuity is a financial product that allows an individual to invest a lump sum of money or make periodic payments to accumulate funds over time, deferring tax payments until the funds are withdrawn, usually at retirement. This type of annuity is designed to provide income during retirement and can be appealing due to its potential for tax-deferred growth.

5 Must Know Facts For Your Next Test

1. Deferred annuities come in two main phases: the accumulation phase, where money grows tax-deferred, and the distribution phase, where withdrawals are taxed as ordinary income.
2. There are generally two types of deferred annuities: fixed and variable, offering different levels of risk and potential returns.
3. Investors often choose deferred annuities to help save for retirement due to the tax benefits and the potential for long-term growth.
4. Withdrawal penalties may apply if funds are taken out before a certain age, usually 59½, making them less liquid than other investment options.
5. Some deferred annuities offer riders, which are optional benefits that can provide additional features like income guarantees or death benefits.

Review Questions

• How do the accumulation and distribution phases of a deferred annuity function?
  • The accumulation phase of a deferred annuity allows individuals to invest either through a lump sum or regular contributions, leading to tax-deferred growth on the investment. This phase continues until the individual decides to start taking distributions, which marks the beginning of the distribution phase. During this phase, withdrawals are made, and they are subject to income tax, making it important for retirees to plan their withdrawals carefully.
• Discuss the differences between deferred annuities and immediate annuities in terms of payment structure and timing.
  • Deferred annuities differ from immediate annuities primarily in their payment structure and timing. With deferred annuities, payments do not begin until a future date, allowing investments to grow tax-deferred over time. In contrast, immediate annuities start paying out almost immediately after a lump sum is invested. This difference makes deferred annuities more suitable for long-term retirement planning while immediate annuities provide quicker access to income.
• Evaluate the impact of tax deferral on investment growth in deferred annuities compared to standard taxable accounts.
  • The tax deferral feature of deferred annuities can significantly enhance investment growth compared to standard taxable accounts. In taxable accounts, any earnings from investments such as interest or capital gains are taxed in the year they are realized, reducing the amount available for reinvestment. In contrast, with deferred annuities, taxes on earnings are postponed until withdrawals occur, allowing more capital to remain invested and compound over time. This can result in a larger nest egg at retirement if managed properly.

Related terms

Immediate Annuity: An immediate annuity is a type of annuity that starts making payments to the investor almost immediately after a lump sum payment is made.

Fixed Annuity: A fixed annuity offers a guaranteed return on investment and provides regular payments at a fixed rate for a specified period or for the lifetime of the annuitant.

Variable Annuity: A variable annuity allows the investor to allocate their funds among various investment options, with payments that can fluctuate based on the performance of those investments.